How does Forex trading work?

Forex trading allows traders to make or lose money based on price changes between 2 different currencies. But what is forex exactly and how do you trade forex?

What is Forex?

The foreign exchange market, or forex for short, is the buying and selling of currencies, and it's one of the fastest-growing markets in the world.

What is forex trading?

So you’ve decided to start learning about trading Forex. While technically it’s not that complicated of a process, you still need to learn the basics before you begin. There are 5 basic concepts you should understand when starting out: what is Forex, how does Forex work, what are the main trading strategies, what affects the rates, and how to read a Forex quote.

Forex — short for “foreign exchange” — is a global market for exchanging national currencies with one another. For example, one American dollar can buy 0.745 British pounds; if the exchange rate rises then it will cost more pounds to buy an American dollar. This fluctuation in exchange rates is measured in pips, or percentage in point — usually 1/100th of a percent where one pip equals 1 basis point or 0.0001 (one ten-thousandth).

Key terms in forex trading

As a forex trader, you may have heard the following terms: pip, lot, margin, leverage and bid/ask. While these are all important parts of trading in the foreign exchange market:

Pips

A pip is a unit of measurement for forex trading. It's also the smallest amount of money that can be made or lost per transaction. For example, if you tried to buy 1,000 pounds of coffee from your local supermarket, and the current price was $2 per pound, you'd pay $2,000 for 1,000 pounds (1 kilogram) of coffee. If the price was $3 per pound, you'd pay $3,000 for 1,000 pounds (1 kilogram). The difference between those two scenarios is a pip: A single unit of measurement that describes how much a currency moved in relation to another currency.

In this case, a pip is equal to 0.01%—meaning that if the price moves 1% away from its original value (in this case going from $2 to $3), you'll lose 0.01% of your money as a result.

Lots

A lot is a set number of units that make up the smallest possible trade on a particular market. In forex trading, investors typically use a standard lot of 100,000 units.

Margin

Margin is the minimum amount of money required in your account to open a position as a percentage of the notional value of the position. Investors can use margin to leverage their trades and increase their potential gains by using leverage.

Leverage

Leverage refers to how much you can multiply your trade size by using borrowed funds or credit, which is what allows you to take larger positions without putting up the full amount for the trade.

Bid And Ask Price

The bid price is the highest price a buyer will pay for a currency pair, while the ask price is the lowest price a trader will sell it for. The difference between these two prices makes up what's known as "the spread."

How to open a forex account

When it comes to Forex trading, a lot of people look into opening an account with a broker. They have their reasons. There are some brokers that charge you for the demo accounts, some brokers that don't provide one, and some brokers that offer both.

In our experience, it is important to learn about how Forex works before you open a full-fledged account with a broker. First of all, you need to understand how currency pairs work and what a forex pair is. Second of all, you need to learn about the product that each broker offers so that you can make the right decision when looking for an online forex broker (demo or live). After learning about these things and making sure your requirements meet those requirements, you should be able to open an account with any company as long as they have decent customer support and quality products/services.

How to make your first forex trade

To open a trade, you’ll need to decide on the following:

  1. The currency pair you wish to trade (e.g. AUD/USD)
  2. Which lot size do you want to trade (e.g. 0.1 lots or 1 lot)
  3. The price at which you’d like your order filled
  4. Whether you want to enter a long or short position by choosing either ‘Buy’ or ‘Sell’ respectively

To close your position and take profits, you can either:

Enter an opposite trade and choose “Close Trade By ID” in the Order window, OR Choose “Close Trade By ID” in the Order window without entering another trade to close. You will then be prompted for the ticket number of the trade that you wish to close. Alternatively, if your platform supports it, right-click on the position and select “Close Order."

How do you make money on the forex market?

Let's say that you think the euro will increase in value against the US dollar. Your pair is EUR/USD. Since the euro is first, and you think it will go up, you buy EUR/USD. If you think the euro will drop in value against the US dollar, you sell EUR/USD.

Should your prediction turn out to be right and the exchange rate increased, your profit would be $100 minus whatever commission or fees were charged by your bank or broker (let's assume they took $10 out of that amount).

But, assuming your prediction was wrong and the exchange rate fell instead of rising, then you would have lost $100 minus any fees charged by your bank or broker.

Closing a trade in profit

If you have a profitable trade, it’s time to tell your broker to close the trade.

Most traders will use a so-called “stop-loss” order to limit their losses on each position they take in the market. A stop loss is an instruction you give your broker that automatically closes your position once the price falls by a certain amount (you set this amount). If you don't set a stop loss and the market goes against you, there's no limit to how much money you can lose.

To adjust or remove your stop loss, simply right-click on the open trade in your account and choose “Modify or Delete Order."

A forex strategy for beginners

  • Don't get carried away by the news.
  • Don't trade when you're drunk.
  • Have a trading plan, and stick to it!
  • Don't get emotional.
  • Use your demo account!
  • Follow your strategy.
  • Understand the risks. If you don't understand, you shouldn't be trading these instruments (yet).
  • Don't trade too much! Start with small amounts so that you can focus on making good decisions rather than making money at all costs.

Forex trading risks

Forex trading is not immune from risk. Different kinds of risks can have different effects on your bottom line, so it's important to manage your risks appropriately. There are four main types of Forex trading risk: counterparty risk, market liquidity risk, operational risk, and capital adequacy risk.

Counterparty (or credit) risk is the chance that both you and the other party in a transaction cannot fulfill your obligations to each other. Unfortunately, this is not just limited to the other person defaulting on a payment – any third-party intermediary between two parties in exchange also represents counterparty or credit risk to both sides of the transaction. This includes things such as payment gateways used to process payments and even cryptocurrency exchanges themselves.

Market liquidity risk refers to how well you will be able to liquidate your positions after entering into a trade. While there are many factors affecting this type of market volatility (including high-frequency trading algorithms), it usually has more to do with basic supply-and-demand economics than anything else. If there are no buyers for what you're selling – or if there is simply too much supply relative to demand – then you may have difficulty exiting.

Meet the forex major pairs

There are 6 main pairs, which represent the currencies of the world's largest economies. These 6 currency pairs are known as the majors, and they are by far the most popular currency pairs traded in forex.

Major pairs all contain US Dollar (USD) on one side; therefore, they are referred to as dollar pairs. Because these major currencies have a relatively large number of traders and high liquidity, they tend to experience lower volatility than other currency pairs. The most frequently traded ones are EUR/USD, USD/JPY, GBP/USD and USD/CHF. They usually have tight spreads (the difference between buying and selling prices), making them perfect for beginners who want to minimize trading costs.

These major currency pairs account for more than 80% of global trade. If you're just getting into forex trading, then it's important that you choose a pair from this group that best fits your style of trading and personal interests.