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What is Forex Trading and How Does It Work?

FX Scouts By Jeffrey Cammack Updated: November 26, 2019
How does Forex trading work?
Source: Getty Images

What is Forex Trading?

Forex trading is the exchange of one currency into a different currency. Most of this exchange occurs on the Forex market, a global decentralised market which is open 24 hours a day, Monday to Friday. As the Forex market is decentralised it does not rely on exchanges and instead operates through a network of international banks.

The Forex market is the largest market in the world with a daily trading volume of approximately 5 trillion USD. Because so much currency is constantly being traded, exchange rates are always fluctuating, and Forex traders seek to take advantage of this volatility.

Though the Forex market operates 24 hours a day, volatility tends to peak during the normal opening hours of stock markets in Sydney, Tokyo, New York and London. The highest volume of trading generally occurs at the overlap of the London and New York opening hours.

What affects currency exchange rates?

Like all markets, currency prices are set by supply and demand. But the constant shifts in supply and demand of the dozens of frequently traded currencies makes the Forex market more complex than most. Happily, there a few indicators that traders can use to help them predict price movement.

Central Bank Economic Policy

National economic policy, set by central banks such as the Bank of England in the UK or the Federal Reserve in the USA, can have major effects on currency prices. Following the 2008 crash, some central banks engaged in quantitative easing, or increasing the supply of money in circulation, which causes a currency’s price to drop. On the other hand, raising interest rates (usually used to combat inflation) will cause a currency’s price to increase as this leads to higher investor demand.

If economic policy changes without warning it can create major fluctuations in currency value. In 2015 the Swiss National Bank (SNB) abruptly scrapped the Swiss Franc’s peg to the Euro with no warning. This resulted in a huge increase in the value of the franc versus the euro – moving from 1.2 CHF/EUR to 0.86 within hours of the news.

Current Events

Current events can also affect the price of a currency. The ongoing Brexit debacle in the United Kingdom is a perfect example: Large investors like to move money into strong, predictable economies; so as Brexit uncertainty continued institutional investors moved their capital out of the country, decreasing demand for the GBP and causing it to lose value. Once it appeared that the British Parliament had successfully agreed on a Brexit deal, the value of the GBP rose again.

You can see this effect anywhere you look in the world, if a good piece of economic news appears about a nation-state, its currency will increase in value. If the news is negative, the currency’s value will decrease. As a rule, the better health a country’s economy is in, the stronger and more stable its currency will be.

How does Forex trading work?

Rather than thinking of Forex trading as currency exchange, it better to think of it like any other market. On a stock exchange, for instance, you buy an asset (stocks) with currency. In the case of Forex trading, it just so happens that the asset you are buying is also a currency.

Unless you are a large bank or institutional investor, Forex trading is a form of Contract for Difference (CFD) trading. CFD trading is speculation on the value of an asset – traders do not take ownership of the asset itself. This also allows traders to speculate on either an increase or a decrease in the asset’s value.

A Forex trade has four main components – the asset, the size of the trade, the price, and the direction (buy or sell). Each of these is unique and affects the profitability of the trade.

The Asset: Currency pairs

In Forex trading, the asset is always a set of two currencies called a currency pair. Currencies are quoted in pairs, as the two currencies in a pair are bought and sold simultaneously. An example pair is the EUR/USD (euro/U.S. dollar).

Currency Pairs

The first currency of any pair is called the base currency and the second currency is called the quote currency. In the ZAR/USD, the Rand is the base currency and the US Dollar is the quote currency.

The price: Forex quotes

The value of a currency is called a quote or a price. As currencies are quoted in pairs, the value of the quote currency is set in relation to the base currency.

For example, if the EUR/USD is priced at 1.1332, it means that 1 euro can be exchanged for 1.1332 US dollars. In Forex trading, the change in price of one currency relative to another is what generates a profit or loss.

Forex Quotes

Pips: Calculating price fluctuation

Price fluctuation (or the difference between two prices) is often measured and expressed as a value in pips. A pip is a small change in the value of a pair and is measured in the 4th decimal place; for example, if the EUR/USD trades at 1.1332, a one pip price increase would move the exchange rate to 1.1333.

There are exceptions to this rule, the most notable being Japanese yen quote pairs, such as USD/JPY, where a pip is a change in the 2nd decimal place.

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

Quotes and Spreads: Ask price, bid price and trading costs

The value of a currency pair is expressed using a two-price quotation system: One price is for buying – or going long – and is called the bid price, this will be slightly above the market price. The other price is for selling – or going short – and is called the ask price, this will be slightly below the market price. The prices are set by your broker and the difference between the two is called the spread.

It’s best to see the spread as a broker’s fee for using its trading platform. The spread is measured in pips and is often the largest component of your trading costs. The spread is typically different for each currency pair and is influenced by factors like the pair’s liquidity, the broker’s mark-up and the broker type. Some brokers offer very tight spreads, often based on the raw interbank rate, and in these cases you will pay commission on every trade.

Here is an example of a 1-pip spread on the EUR/USD pair:

  • Bid price:1.1332
  • Ask price:1.1333

The ask price minus the bid price = 0.0001 = 1 pip.

Trade size: Lots, mini lots, micro lots and nano lots

The size or volume of a trade is measured in lots. This is similar to how stocks (equities) are measured in shares and gold, which is measured in ounces.

Forex Lots

 

One standard lot is 100,000 units of a currency pair. So, if you buy one standard lot of the EUR/USD, you’re entering a trade worth 100,000 euro (which is more than USD 100,000).

One mini lot is 10,000 units of a pair. A mini lot of the EUR/USD is worth 10,000 euro.

One micro lot is 1,000 units of a pair. A micro lot of the EUR/USD is worth 1000 euro. In most cases, a micro lot is in most cases the smallest trade you can place, though some brokers will offer nano lots of for smaller account types.

If you don’t know how to calculate the correct lot size for your trades or if you need help in calculating the pip-value for a certain lot size, take a look at How to Place My First Forex Trade.

Leverage: Amplifying exposure but increasing risk

Trading with leverage involves borrowing money from a liquidity provider to greatly increase the size of your trade. A trader will place a small deposit, known as the margin, and the rest of the trade value will be leverage. Your profit or loss will be based on the full value of the trade, not just your margin.

Most CFDs are traded with leverage because they allow traders to open much larger positions than their account balance would normally allow.

Leverage

Using high leverage can increase your profit potential considerably but will also considerably increase your risk. Traders who use excessive leverage are exposing themselves to significant losses.

Here is an example to demonstrate how leverage can be used to place larger trades with less capital:

Let’s say you have a small trading account of USD 100. You have access to leverage of 1:500. You place a trade of 0.1 lots (one mini lot) on the USD/JPY pair. One mini lot is 10,000 units of the pair, which means the value of your trade is USD 10,000. Although the notional value of the trade is USD 10,000, only USD 20 of your account is engaged in opening the trade because 1:500 leverage means that you need to put down only 0.2%* of the notional amount of the trade.

*This example doesn’t consider the extra margin required to sustain a position with a floating loss.

Trade direction: Going long or going short

We touched on going long and going short earlier, but let’s look at what we mean in more detail.

CFD traders can speculate on whether an asset will increase or decrease in value and can profit either way.  Profiting from the decreasing value of an asset is unique to CFD trading.

Going Long vs. Going Short

Long is the term used for buying, where the trader speculates that the price of the base currency will rise relative to the quote currency. In simple terms, you will make money from a long (buy) position if the price of the currency pair rises.

Short is the term for selling, where the trader speculates that the price of the base currency will fall relative to the quote currency. In simple terms, you will make money from a short (sell) position if the price of the currency pair declines.

Example – trading 1 micro lot on the EUR/USD 

Let’s say your trading account which is funded with USD 1000 and your account’s leverage is 1:100. The EUR/USD currency pair is trading at 1.20000. You speculate that the EUR will increase in value against the USD and you buy 1 micro lot at 1.20000. You set a stop loss at 1.19000 (100 pips below your entry price) and a take profit at 1.23000 (300 pips above your entry price). One micro lot (0.01 lots) is worth EUR 1,000, which is equivalent to USD 1200 in this scenario. As your account’s leverage is 1:100, only USD 12 of your account is used to open the position*.

*Extra margin is required to sustain a floating loss.

If your trade is correct

The euro strengthens against the U.S. dollar and hits your profit target at 1.23000. The 1000 euro you initially bought for USD 1200 is sold for USD 1230, which means you’ve made a profit of USD 30.

Another way to calculate your profit is to multiply the number of pips you’ve made by the pip value of a micro lot, which is USD 0.10 on the EUR/USD. So, 300 pips multiplied by USD 0.10 gives you a profit of USD 30.

If your trade goes wrong

The euro weakens against the U.S. dollar and hits your stop loss at 1.19000. The 1000 euro you initially bought for USD 1200 is sold for USD 1190, which means you’ve lost USD 10 on the trade.

Another way to calculate your loss is to multiply the number of pips you’ve made by the pip value of a micro lot, which is USD 0.10 on the EUR/USD. So, 100 pips multiplied by USD 0.10 gives you a loss of USD 10.

Trading Strategy: Using Analysis

In Forex trading there is no “best” strategy – the strategy that works for you will be dependent on your personality and lifestyle.

All trading strategies will require you to engage in market analysis in order to be successful. Market analysis can be grouped into two general types; fundamental analysis and technical analysis.

Fundamental Analysis

Fundamental analysis is the study of macroeconomic trends and their effects on price, this form of analysis requires a sound knowledge of economics and current events. In the broadest sense, Fundamental traders try to buy currencies from stronger economies at a low price and sell currencies from underperforming economies.

Fundamental traders are often reliant on scheduled news events that alter currency price. A good example is the Non-Farm Payroll (NFP) report in the United States; the NFP is released on the first Friday of every month and details how many jobs have been added or lost in the US economy. It’s generally seen as a good bellwether of US economic health and if the figure is higher or lower than expected then we will see increased volatility in the Forex market.  

Fundamental analysis can be tough for traders unfamiliar with finance data but for traders who have a firm grasp of the financial news, and understand macroeconomics, this is a very successful approach.

Technical Analysis

Technical analysis is the prediction of future price action based on historical price data. Technical traders make heavy use of charts and will often rely on a variety of tools and indicators to help them identify trends and patterns. Almost all technical analysis is based in Dow Theory, a set of principles laid down in the 19th century by Charles Dow to describe and predict the movement of the stock market.  

The most common form of technical analysis is price action trading, which is essentially the analysis of the actions of all the other market participants. Price action traders believe that market psychology is the main driver of price: They believe that there are many reasons for price movement, but that ultimately, its traders’ reactions to developments.

Technical analysis can be tough to learn, but once you have a good understanding of the basics it can be used in any financial market, not just the Forex market.

Analytical Tools

All good traders will use a combination of fundamental and technical analysis to find opportunities in the Forex market and there are several great tools we recommend to get you started:

  • Autochartist: is a lightweight technical analysis tool that can be plugged directly into your trading platform. It analyses trends in price action and highlights trading opportunities based on automated technical analysis across a huge number of Forex pairs.
  • Trading Central: A more robust analysis database that contains over 8,000 assets, including stocks, commodities and Forex pairings. Analysis, both technical and fundamental, provides data and commentary on each asset.
  • TradingView: An intuitive and advanced financial visualisation platform and active social network for traders and investors. In addition, TradingView offers a huge number of HTML5 charts, stock screeners, hundreds of pre-built technical analysis indicators and a built-in news feed.

Whatever form of analysis you focus on, these tools will help you find your feet and do a lot of the hard work for you – especially on the technical side. Once you get to grips with technical analysis you will probably want to start customising your platform with indicators and algorithmic trading bots that can automate your trading strategy.

Conclusion

Some of these terms and concepts might be tricky to understand at first but it won’t take you long to get it when you see it in action. The best way to learn the basics of Forex trading is to practice on a demo account and place a few trades.

We still have plenty of good information waiting for you! Take a look at the articles below to further develop your skills and knowledge…

Essential reading

Expect to learn a lot before trading profitably.  You need to learn how to operate the software, do analysis, and manage the risk in the account. We have an education section to continue reading and explore many of the principles to succeed in trading. Here are articles most relevant to getting a good start.

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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.