How does Forex Trading Work?

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.

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Currency Symbols

Each currency taking a 3 letter abbreviation, where the first 2 letters represent the country, and the last letter represents the currency.  The South African currency, the Rand, has the symbol ZAR.

ZAR Explained

Some of the most commonly traded currencies are:

  • USD – United States Dollar
  • EUR – European Union Euro
  • GBP – Great Britain Pound
  • AUD – Australian Dollar
  • JPY – Japanese Yen

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.

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

The change in the value of currencies is measured in pips.

What is a Pip in Forex Trading?

The term Pip is an abbreviation of Percentage in Point and is the smallest possible movement in the value of a currency pair.  A currency is valued to the 4 or 5 decimal places, where a pip is the movement of the 4th decimal place either up or down. If the USDZAR currency pair changes value from 13.55251 to 13.55211 then there has been a change of 4 pips.

Another example with EUR/USD.  A change in the value of the currency pair of 0.0001 would be measured as 1 pip and a change of 0.0010 would be 10 pips.  For more detail on what pips are and how to calculate them continue reading here.

Forex Quotes

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:

  • 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

As an example, if the USD/ZAR is quoted at 13.55251, to buy $1 you need to pay R13.55251.

USD/ZAR Bid & Ask Price Example

The difference between the two is quite small and is called the spread and it is measured in pips.

The Spread in Forex Trading

The “Spread” is the difference between the bid and ask price value of the currency pair.  This small difference in the pricing is how your Forex broker makes their money for offering you the service that connects you to the International currency market.

Leverage & Margin in Forex Trading

Because the movements on the currency market, traders need a way to magnify the size of trades.  Leverage is used to do this, and it is found in all forms of CFD trading.  Leverage is offered through your forex broker, and if often provided by a third party like a bank.  This means that with a very little money, you can make big trades, by only putting up a deposit to protect against the loss.

The deposit to protect against the loss is called Margin.  Once a trader has decided on the currency pair they want to trade and the size of the investment, we need to make sure we have the margin available in the account.  If the margin is not available, the broker will not allow us to open the trade.

Is Forex Trading Risky?

Forex trading is where a trader speculates of the values of currency pairs over time.  There are many factors that are out control of the trader and these factors are what adjust the value of currency paries.  Because a trader has no way to directly influence the market, Forex trading is very risky.  A trader can easily lose all of the money they have deposited to their account.  Most traders lose it all within months.  Read here for more on risk management in Forex trading.

Forex Orders to Manage Risk & Profit

Forex traders must think about the exit from a trade before they enter a trade.  A trader will either exit the trade at a profit, or at a loss depending on the changes in the market.  In order to ensure that we don’t lose too much, or to lock in the profits of a trade, traders can use Orders.

A stop-loss order is used to protect your account.  A stop-loss order states that should the value of the currency pair drop and reach a set figure, the trade will automatically close and protect the trader from losing more.  A take-profit order when passed will close the trade taking in all the profit that has been made.  This a way to guarantee the wins from the trade.

Forex Orders are used to manage risk in Forex trading and are easily set up if you use MetaTrader.  Unless you really know what you are doing, you should learn how to trade Forex by practicing to use different order types.  Examples of how they can be used can be found here.

Demo Accounts In Forex Trading

The best way to learn to trade Forex is by using a demo account.  This can be useful for these three reasons:

  • With a demo account, you don’t deposit money.  The way it works is that a broker will load an account with play money to trade with on their software, and with the live market data.  This is the best way to learn because it is risk-free.  Terms on demo accounts can be different so this is our selection of the best brokers for demo accounts.
  • With a demo account, you can practice doing some analysis.  If you are going to be a successful trader you will need to learn how to analyze charts (technical analysis) and also understand how news events can affect the markets (fundamental analysis).  Read more here about the difference between fundamental analysis and technical analysis.
  • With different demo accounts, you can try the different software platforms used in trading – different brokers will have their own software that allows traders to use special tools and functionalities specific to that brokerage.  An example would be how eToro has social trading and needs a web browser to give clients access to those features, while others have a common platform called MetaTrader.

How to get started?

  1. First, you need to read around this website and find a broker that appeals to you.  Each broker has their pros and cons, but all of the brokers we feature on this site are trustworthy will be able to get you started.  Many of them have either webinar content or with an experienced trader to introduce you to some of the below concepts.  For more on how we review and chose broker to promote, check out our about us page.
  2. Secondly, you need to open an account with a forex broker as they are the way that you access the international forex market.  Click on any of the “sign up” buttons located around our site to take you directly to the forms you need to complete to apply for an account.
  3. Thirdly, your account is not complete without verifying your identity by uploading documents.  The only way that a broker can keep the trading environment safe is to know the true identities of all the traders.  This is also a requirement of the regulators to ensure money laundering does not take place on the platform.  It is a part of the Know Your Customer framework that promotes transparency in trading.
  4. Finally, your broker will call you, so answer the phone.  Many people hide from the phone calls, but if you are serious about trading you should have a discussion the broker so they can give you the tools to get you started.

Trading on Mobile Phones & 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.

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.

Now what?

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

This amount of learning is not enough, however.  We have an education section where you can continue reading and explore many of the principles to success in trading.