How does Forex Trading Work?

What is the Foreign Exchange Market?

The foreign exchange market is the largest in the world with over 5.1 trillion Dollars being traded daily in April 2016 (BIS Triennial Central Bank Survey Foreign exchange turnover in April 2016) by banks and private retail traders.  The market is decentralized, which means there is no single physical location where the transactions take place and instead all trades are managed by a single digital platform that is open 24 hours, 5 days a week.

What is Forex trading?

Forex trading is speculating on (buying and selling) the value of currency pairs.  For example, a Forex trader would sell USD (US Dollars) and buy ZAR (South African Rand) with the hopes that the value of the ZAR increases. When the value of the ZAR increases, the trader sells the ZAR currency making a profit.  Forex trading is done using a Forex broker on the Internet as they will be your link to the International money markets.

What Sets Forex Trading Apart from Other Trading?

The value of currency pairs is not always directly correlated to commodity, bonds, shares market around the world, and this offers a unique opportunity for investors.  In times when traders believe that physical assets like property, and to some extent, shares are not going to have a positive trend, Forex trading offers an opportunity to profit from an uncertain or downward moving market. In 2008 Betsy Waters, then Global Director of Deutsche Bank’s Online investment platform, stated:

One of the most important reasons to consider investing in FX is that it has a track record of generating positive returns on a consistent basis. Research conducted by Deutsche Bank shows that FX Investments returned 11 percent a year on an annualized basis between 1980 and 2006 with 21 positive returns and five negative return years.Betsy Waters

For the experienced trader, this speculative market offers continuous opportunity if you know where to look, and react to the right data and market news.

In Forex trading currencies are traded in pairs

Currencies are quoted in pairs, as whenever a trader sells a currency another currency must be purchased at the same time.  Forex trading centers around the relative value of one currency against another.  Forex pairs are made up of a base currency and a quote currency.

  • Base currency is the currency you are buying when you trade the forex pair
  • Quote currency is the currency you are selling when you trade the forex pair.

Not all currency pairs are trading equally.  As an example, from the 2016 Triennial Central Bank Survey by the International Bank of Settlements, “the US dollar remained the dominant vehicle currency, being on one side of 88% of all trades” (source – highlights – pdf).  This means that for a significant portion of the time you will be trading USD currency pairs

How Forex Trading Works

A Forex trader buys and sells currency pairs, with the hopes that the value of the currency changes and they make a profit.  Let’s take an example where a Forex trader sells 200 USD to buy ZAR (South African Rand).  At the current time, the exchange rate between this currency pair is 13.55251.  This means that for every USD, you get 13.55251 ZAR in return.  When we sell the 200 USD we then have 2710 ZAR.

Selling USD to buy ZAR

After some time we have noticed that the ZAR value has increased against the USD.  1 USD is now worth 12.10251 ZAR.  As a trader, we have now decided to sell the ZAR in exchange for USD.  Because of the difference in exchange rate, we have 224 USD which is an increase of 24 USD or 12% profit.

Selling ZAR to buy USD

Eager To Start?

Forex Quotes & Spreads

The value of a currency pair is called a quote.  A currency quote contains two prices. The forex market uses a two-price quotation system that includes two prices – one for buying and one for selling.  This is called the spread.

  • The bid price is the maximum price any buyer is willing to pay for the currency
  • The ask price is the minimum price any seller is willing to accept for the currency

How To Calculate the Spread

In the example above, the difference between the sell price and the buy price is 0,0082 or 82 pips.  A pip is the smallest change in value a currency can make.  If you are going to make a profit in your trade, you must first calculate the number of pips in value the currency needs to change so as to cover your spread.

Calculate It Yourself!
To calculate your profit in pips, use the following equation.  Profit in Pips = Change of Value in PipsSpread in Pips.

Leverage in Forex Trading

Leverage is used in Forex trading as a multiplier of the size of your trade.  As changes on the Forex markets are so small, it would be nearly impossible to make a profit without it.  In order to multiply your trade value by 50 times, you would use a 1:50 leverage as you enter the trade.  So if your trade without leverage would earn you a profit of 2 USD, that same trade with 1:50 leverage would earn you 100 USD profit.

However, leverage can both work for you and against you depending on how your trade moves.  If the trade moves against your position, you are required to take the loss of the full leveraged amount from your account balance.  Using high leverage adds significant risk to your account balance, and thus leverage was restricted by CySEC in 2018 for all non-professional European traders to a maximum of 1:30 Source – CySEC.  This has not yet been introduced by FSCA, and so does not limit South African traders.

Power Tip
Using leverage is important for trading, but using the right leverage for a trade is even more important.  Calculate your potential gains and losses before committing to your trade when using leverage.

How Do I Get Started With Forex Trading?

Forex brokers offer different spreads and leverage to their clients, as well as being regulated by different entities around the world.  Now that you understand how Forex trading works, it is time to look at how to get started with comparing brokers.  A broker is your connection to the Global market, and without them, you won’t be able to start.

Our Top Forex Brokers

How To Choose Accounts Types in Forex Trading

Brokers will offer a small variety of accounts for different traders.  There will also be a live account and a demo account, and with some brokers, there will be some variations on the live account to give higher depositors better trading conditions.

Live Accounts with the Best Brokers – Best real trading accounts for investors ready to deposit

Choosing a live account can be an intimidating task as there can be different accounts options to choose from.  When choosing between live accounts, start by considering the minimum deposit to ensure you are comfortable with it and compare the spreads for the same currency pairs with a similar account at a different broker.  We have done much of this work for on our forex brokers review page.

Best Forex Demo Accounts – Best account type if you are just starting out, and don’t have the money to lose.

Demo accounts are 100% free. They are a good way for beginners to trade forex with a real broker without risking any money. Demo accounts often have all the features you would expect from the broker. Plus it gives the trader a good feel for what trading would be like with MT4 or with the broker’s own software or apps.

 

What is the best Forex Trading Platform?
What is the best Forex trading platform?  There are a number of software platforms available to traders.  The most common platform is MetaTrader 4 & 5 which you download to your PC or Mac.  A select few brokers have chosen to develop their own software for traders, but this is usually limited to brokers who offer different features and tools to their users.

Have Questions?

Is Forex Trading Risky?

Forex trading is where a trader speculates on the future value of currencies.  There are many factors that are out control of the trader and these factors are what adjust the value of currency paries.   Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Because a trader has no way to directly influence these factors, Forex trading comes with high risk and a trader can easily lose all of the money they have deposited into their account.  Read here for more on risk management in Forex trading.

Should I open a demo account?

The best way to learn to trade Forex if you are an absolute beginner by using a demo account where you don’t deposit money.  In this case, the broker will load an account with play money to trade with on their software, and with the live market data making it fun and is risk-free.  Open a demo account to practice trading if you don’t feel you can afford to lose the money you would otherwise deposit into a live account.

All traders are different. What kind of trader are you?

Having a trading plan will define you as a trader.  It helps you set up and monitor your trades, it helps you with the entry and exit of your trades, introduces consistency and it will improve your ability to spot trading opportunities.  It will help you reach your goal and the reason why you are starting a trading career.

If you’re planning to become a professional or hobby trader, developing a trading plan should be the first step before getting your feet wet in the markets.

What Are The Top Tips For Successful Forex Trading?
  1. Learn the language of trading.  Before you are able to learn the basics of strategies you will need to understand what a Pip is, what a pivot point is, and what a gap is.  These are just some examples of the language of trading so take some time and learn this new terminology.
  2. Learn money and risk management and know where your currency reserves are.  It is important to understand the kind of trader you are so that you can develop a trading plan to decide how trading is going to fit into your life.
  3. Take notes on the success and failure of your trades so that you can use this analysis to help guide you in the future.  As an example, we have published a historical analysis of the EURUSD pair to give you an introduction to the most commonly traded pair and give you some insights.
  4. Know your exit strategy options for every trade you make.  This helps remove the emotion from the trade, and you will be trading more discipline.

Read our 7 Vital Forex Trading Tips for Beginners to get you started on the right foot.

Can I trade on a mobile phone with apps?

Traders often like to use mobile devices while away from desktop computers or tablets.  There are advantages to trading with a broker which as a good mobile application available to you, but I would discourage trading solely on a mobile device – simply because of screen size and how much better it can be to research on a bigger screen.

I often use a mobile device for monitoring ongoing trades, and entering into trades should I be away from a computer when significant news events happen.  To read more about the features of forex trading apps read our article here.  Mobile devices can also be good for adjusting your stop-loss or take-profit.

Can someone else manage my account?

Often with a much higher minimum deposit, your money would be managed by a 3rd party, just as you would put your money into the hands of a fund manager.  This does not mean that your trading is going to have any less risk, but it does mean that you don’t need to be active in doing research and monitoring your funds.  Very few brokers, however, offer this service, but some do.


Now what?  Keep Learning.

This is a very high-level overview of how to trade forex on the international markets.  You have learned some of the basic vocabularies of Forex trading, you know what a currency pair is, and you have read some tips and strategy to get you started.

Learning to trade Forex is going to take time.  For someone who has never invested before you will find that you have a lot to learn in order to trade profitably.  You will need to learn how to manage the software, do both fundamental and technical analysis, and also learn about the psychology of a trader.  So to set the right expectations from the beginning, expect this learning period to last years, and not weeks or months.

That said, we have an education section where you can continue reading and explore many of the principles to success in trading.  Some of the questions we think you should answer in to better understand how Forex trading works are here to give you a flying start.

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