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How does Forex Trading Work?

By Jeffrey Cammack Published: October 13th, 2018 Updated: June 10th, 2019
How does Forex trading work?
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We have written this short, easy-to-read guide to how Forex trading works with explanations of the key concepts and terminology used.

What is Forex Trading?

Before we look at how it works, we need to define what it is.

Forex trading is the buying and selling of two currencies simultaneously on the Forex market. If you place a buy order on the ZARUSD pair, you are buying the ZAR and selling USD with the hope that the value of ZAR will increase relative to the USD. If the ZAR has increased in value when you close your trade, you will make a profit.

Forex trading is a form of CFD trading. CFD trading is speculation on the value of an asset, where the trader does not take ownership of the asset itself. Also, because it is speculation on the value of the asset, the trader can make money by speculating on either an increase or a decrease in the value of the asset.

How does Forex trading work?

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 pair

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

The first currency of any pair is called the base currency and the second currency is called the quote currency. In the EUR/USD, the euro is the base currency and the U.S. dollar is the quote currency.

The price – Forex quotes

The value of a pair 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 U.S. dollars. In currency trading, the fluctuation of the value of one currency against another is what generates a profit or loss.

Price fluctuation is calculated in pips

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 (with the exception of Japanese yen pairs and some other pairs).

For example, if the EUR/USD trades at 1.1332, a one pip price increase would move the exchange rate to 1.1333.

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

What are quotes and spreads?

The value of a pair is quoted using a two-price quotation system – a price for buying and another for selling. These prices are set by your broker and the difference between the two is called the spread.

Assuming there is no slippage when you open a buy (long) trade, your order gets executed at the ask price. This is the lowest price at which your broker is willing to sell the pair to you at that specific moment. When you close that same trade (by selling the position to the broker), you will receive the bid price, which is usually lower than the ask price. The bid price is the highest price your broker is willing to pay for the pair at any specific moment in time. If the bid price rises to the level you bought the pair at, your trade will be at break-even.

Conversely, when you open a sell (short) trade, your order gets executed at the bid price. This is the highest price your broker is willing to pay for the pair at that specific moment. When you close that same trade (by buying it back from the broker), you will pay the ask price, which is usually higher than the bid price. The ask price is the lowest price your broker is willing to receive for selling the pair at any specific moment in time. With a short trade, your trade will be at break-even when the ask price declines to the level at which your trade was executed.

  • Bid= the price at which the broker is willing to buy the currency pair.
  • Ask= the price at which the broker is willing to sell the currency pair.

The spread is measured in pips and is an important component of your transaction cost. The spread is typically different for each currency pair and is influenced by factors like the pair’s liquidity and the broker’s markup. Some brokers offer trading accounts with raw interbank spreads. In this case, there is no markup on the spread itself but 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.

The trade size – 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.

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 $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. A micro lot is in most cases the smallest trade you can place.

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 amplifies volume

Leverage is used as a multiplier of the size of your trade.

Most CFDs can be traded with leverage, which enables a trader to place larger trades than his account balance allows, by borrowing additional funds from the brokerage or a connected 3rd party.

Using high leverage can increase your profit potential considerably while at the same time increasing your risk. Traders who use excessive leverage are exposed 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 $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 $10,000. Although the notional value of the trade is $10,000, only $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).

The direction – long (buy) or short (sell)

CFD traders speculate on whether an asset will increase or decrease in value, and can profit when the price the asset moves higher as well as when it moves lower.

Turning a profit from a decreasing value of an asset is unique to CFD trading.

Long is the term used for buying, where the trader buys the base currency while selling the quote currency. A profit is made if the value of the base currency increases against 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 sells the base currency while buying the quote currency. A profit is made if the value of the base currency declines against 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 $1000 and your account’s leverage is 1:100. The EUR/USD currency pair is trading at 1.20000. You speculate that the euro will increase in value against the U.S. dollar 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 1,000 euro, which is equivalent to $1200. Because your account’s leverage is 1:100, only $10 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 $1200 is sold for $1230, which means you’ve made a profit of $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 $0.10 on the EUR/USD. So, 300 pips multiplied by $0.10 gives you a profit of $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 $1200 is sold for $1900, which means you’ve lost $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 $0.10 on the EUR/USD. So, 100 pips multiplied by $0.10 gives you a loss of $10.

Conclusion

Some of these terms and concepts might be tricky to understand at first but it doesn’t take long to get accustomed to the basics. The best way to learn Forex basics 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.

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.