What is Forex Trading and How Does it Work?

Gabriel Sherman

Forex, or foreign exchange, refers to the exchange of one currency for another. Forex has become one of the most popular forms of trading and investing among institutions and individual traders alike.

Like most things in life, Forex should be approached through careful planning, smart spending, and infinite patience. If it were a culinary dish, Forex would be a crème brûlée: it takes practice, it’s not cheap, and it’s a bit of a wait.

But the results can make it all worthwhile.

Entering the Forex arena without this trading trifecta is relying on pure luck as your trading strategy. So, if you’re thinking about getting your start in Forex trading, you’ll need to have an uncompromising commitment to these principles.

If that’s you, then let’s start at the beginning.

What is Forex Trading?

Foreign exchange, or Forex, is the concept of exchanging one currency for another. It’s that simple.

That doesn’t sound like a very big deal.

Hold on. Remember that time you flew to Norway to accept the Nobel prize for reading long Forex articles, and you exchanged your US dollars for Norwegian krone? That’s foreign exchange. It’s been going on since currency was invented. (In fact, you may have heard of a famous Galilean who once caused a scene by arguing with some money changers – or, as we would call them today, Forex dealers or brokers.)

In modern times, however, the bulk of the volume traded in the Forex market is done by multi-national corporations, central banks, and other large financial institutions.

Today, the Forex market is worth about $2.4 quadrillion, processing over $6 trillion a day in trades.

How do I get a piece of that?

There are a couple of ways to make money in Forex. One is by exploiting interest rate differentials, and one is by profiting from the exchange rate.

Let’s say you exchanged $100 for the equivalent in Japanese yen, and then bought a Japanese government bond. And let’s say that the Japanese interest rate is 6%, and the US interest rate is 2%. The interest rate differential – and your profit – is 4%. However, in an era of permanently low interest rates, the potential opportunities here are very limited.

Alternatively, you can simply buy one currency with another, or sell one currency for another, which is the most common form of Forex trading, where you then convert it back later to complete the trade, hopefully at a profit. For example, you can “bet” that the euro will rise in value against the US dollar and make money when that happens.

Ok, so it’s a legal form of gambling.

Not quite. That’s why I put the word bet in quotes. Guessing the movements of currencies is as surefire a way to lose money as giving it to a stranded Nigerian prince. Traders who are successful in Forex trading get there by conducting careful analyses of the markets and making educated predictions for price movements (but more on that later).

Before we go further, let’s quickly define some basic Forex terms so you’re more in the know (don’t worry, we’ll go through these more in depth throughout the article):

  • Ask – the minimum price for which someone is willing to sell a currency.

  • Bid – the maximum price for which someone is willing to buy a currency.

  • Bear market – when the general outlook is that the currency (or other asset) will fall.

  • Bull market – when the general outlook is that the currency (or other asset) will rise.

  • CFDa Contract for Difference is a way to trade without owning the underlying asset, where you buy or sell the difference between the current price and a later price.

  • Leverage money you borrow from the broker to place trades.

  • Lot size – a lot is a measurement used to trade currency, usually equivalent to 100,000 currency units (mini lots are 10,000 units, and micro lots are 1,000).

  • Margin – the amount of money you keep in your account.

  • Pip – a measurement of price movements, where 1 pip = 0.0001.

  • Spreadthe difference between the bid price and the ask price.

Now I think we’re ready to talk about the Forex market.

What is the Forex Market?

When I talk about the Forex market, I am mainly referring to the trading of international currencies, although the term can loosely include the trading of commodities and stocks as well.

Unlike the stock market, which has a centralized exchange, the Forex market is “over the counter” – meaning that banks and institutions trade currencies with each other, without a centralized and controlled exchange.

People like things that are de-centralized. Just ask Bitcoin brokers.

There are four major Forex trading centers: New York, London, Tokyo, and Sydney. Trading takes place across those four time zones, 5 days a week. This impacts the best time to trade Forex.

All currencies are traded in pairs, expressed in this format: XXX/YYY, where XXX is the currency you’re buying (the “base” currency), and YYY is the currency you’re giving in exchange (the “quote” currency). So, if you’re trading the most popular pair in the Forex market, the EUR/USD, that means that you’re buying 1 euro with US dollars. Similarly, if you’re trading the USD/CAD currency pair, you’re buying 1 Canadian dollar with US dollars.

Here are the major currencies that are traded in the Forex market:

  • As I mentioned, the EUR/USD is the most traded pair, with the euro itself being the second most traded currency, in about 39.7% of trades.

  • The Japanese yen (JPY) is the third most traded currency, in about 25.7% of trades.

  • The British pound (GBP) is the fourth most traded currency, in about 20.7% of trades.

  • The Australian dollar (AUD) is the fifth most traded currency, in about 11.48% of trades.

  • The Canadian dollar (CAD) is the sixth most traded currency, in about 8.0% of trades.

  • The Swiss franc (CHF) is the seventh most traded currency, in about 7.0% of trades.

  • The New Zealand dollar (NZD) is the eighth most traded currency, in about 5.7% of trades.

All those currencies, when traded against the USD, are considered the major pairs.

Here are the minor currency pairs, or “cross pairs,” which do not include the US dollar and are not traded as often as the majors:

  • GBP/CAD — British pound/Canadian dollar

  • EUR/GBP — Euro/British pound

  • GBP/JPY — British pound/Japanese yen

  • NZD/JPY — New Zealand dollar/Japanese yen

  • EUR/JPY – Euro/Japanese yen

  • CHF/JPY — Swiss franc/Japanese yen

  • EUR/AUD — Euro/Australian dollar

Then there are the exotic currency pairs, which consist of emerging market currencies:

  • USD/HKD – US dollar/Hong Kong Dollar

  • EUR/TRY – Euro/Turkish lira

  • GBP/ZAR – British pound/South African rand

  • JPY/NOK – Japanese yen/Norwegian krone

  • AUD/MXN – Australian dollar/Mexican peso

  • NZD/SGD – New Zealand dollar/Singapore dollar

Exotics, of course, are traded even less than the minors.

Got it. Now how do I make my money?

It all comes down to the “bid/ask spread,” which is where the real fun begins.

What is Spread in Forex?

The bid/ask spread (or buy/sell spread) is the difference between the bid price, which is the maximum someone is willing to pay for a currency, and the ask price, which is the minimum someone is willing to accept to sell the currency.

I don’t understand. Give me an example.

Let’s say you have finally accepted Queen Elizabeth II’s invitation to be knighted at Buckingham Palace. When you first arrive in England, you will need to exchange your US dollars for British pounds. The exchange dealer at the airport will sell you those pounds at an ask price of, say, 1.36 USD, which means he’ll sell you 1 British pound for $1.36. So, if you need 1,000 GBP for your trip, you’ll need to fork over $1,360 for those pounds.

On the way back home after you’ve been knighted, you realize you still have the 1,000 GBP because the trip was all-expenses paid, courtesy of the Royal Palace. The Forex dealer will buy those pounds back from you at a bid price of, say, 0.70 USD, which means he’s willing to pay you $0.70 per 1 GBP – less than what you bought it for. So, you’ll receive $700 in exchange for your 1000 GBP.

The difference between the dealer’s sale price (ask) and purchase price (bid) is called the “spread,” and that’s the dealer’s profit. In this case, the dealer made a profit of $660.

That sounds simple enough. I think I’m ready!

Easy there, Sir Trades-a-Lot. We need to talk about how currency movements are measured, which is in units called “pips.”

A pip is a “Percentage in Point.” A pip is equal to 0.0001, or four decimal places, and it’s the minimum movement a currency makes. So, if the NZD/USD is trading at $1.25432, and then jumps to $1.25442, then it has moved 1 pip.

In certain cases of smaller denominations, like the USD/JPY, even the second decimal place can be considered 1 pip.

A Forex spread is usually expressed in pips.

What is Forex and How Does it Work?

If you’re trading Forex for speculation, you’ll carry out these transactions with a Forex broker, and your profit will come when your price movement predictions come true.

Let’s say you believe that the British pound will rise over the coming hours against the USD. You buy 1,000 GBP from your broker with USD and, because you’ve conducted a proper market analysis (more on that soon), the British pound does indeed rise against the USD. You’ll now sell those pounds back to your broker for more USD than you used to purchase them with, and voila, there’s your profit.

When you expect a currency to rise, you’re being bullish. When you expect a currency to fall, you’re being bearish.

Why bring animals into this?

We think it has to do with the fact that when a bull attacks an opponent, he thrusts upward with his horns, and when a bear attacks an opponent, he swipes downward.

There’s also Forex for hedging, where you can buy or sell currencies in advance, so that you lock in an exchange rate rather than take a nasty loss if the trade goes the other way. Options and futures are typically used by multi-national corporations when they operate outside of their domestic markets to try to protect against wild fluctuations in their profit & loss due to Forex price movements.

But when you speculate on Forex prices directly, it’s called the spot market.

So how do they deliver the currency to me?

You don’t really buy the currency itself. That’s another difference between the Forex market and the stock market: when you buy stocks or shares of a company, you own the underlying asset – you actually own a piece of the company. But when you trade in currencies, you’re usually trading the difference between what the currency costs now and what the currency will cost, say, in an hour. This is called a Contract for Difference (CFD). Some brokers also offer spot contracts to trade.

So, when we talk about “trading Forex” or “trading currencies,” we usually mean that you’re buying or selling CFDs, which in turn means that you’re trading the price movements of a given currency.

Who determines those prices?

In short, the market does, through supply and demand. If there is a lot of demand for a currency, then that means there is less supply, so its value goes up. (This is why you can charge much more for a pair of jeans if you slap the word “limited” on it. It’s also the science behind the weird NFT trend.)

Conversely, the more of a currency there is, the less demand and less value the currency has. The more dollars that are printed by the United States Treasury Department, for example, the less the US dollar is worth. You might have heard about the recent global energy crisis and skyrocketing inflation, which are connected to this concept.

Supply and demand are driven by various factors, such as the economic strength of a currency’s host country, tourism, trade flows, central bank policies such as interest rates, etc.

Your job as a Forex trader is to predict how much those prices will fluctuate and then make the appropriate trades. If you buy a currency thinking that the price will go up, you’re “going long.” If you sell because you think the currency will weaken, then you’re “going short.”

How can I accurately make those predictions?

That’s the million-dollar question. Knowing when to go long or short and when to exit a trade are the keys to profitable Forex trading, and if you can do it right, then you can master the art of trading Forex.

In a word, the key to making the right predictions in Forex is conducting a healthy analysis.

I promised we’d talk more about this, so let’s do that now.

A Tale of Two Traders

There are two main methods for analyzing the markets: technical analysis and fundamental analysis.

In technical analysis, a trader will use price charts to analyze a given currency. This is an art form in and of itself because it involves a great deal of discipline and pattern recognition. It’s perhaps a bit drier than a fundamental analysis, but it can be an effective trading strategy.

As a technical trader, you’ll look at the charts used in Forex trading to see how a currency’s price moves over certain time frames and find very precise trade entries.

For example, let’s say you want to trade the USD/JPY currency pair. You might first analyze the pair’s daily chart, which is a chart that shows the pair’s general daily performance over a longer term. You would look for a trend, or any formations or patterns that tell you if the pair is bullish or bearish, and any key support and resistance levels.

You could then zoom in to, say, a 5-minute chart, which shows you the pair’s performance over periods of 5-minute increments, and then choose the exact entry point at which to open your trade. Many Forex experts are known to use this trading strategy.

You kind of lost me there.

I know. The truth is, a walkthrough of the technical analysis method and how to perform it could fill a large book. Learn more about technical analysis and see if this is the right approach for you.

In a fundamental analysis, on the other hand, you’ll base your trades on any relevant news and events that might impact the currency.

Usually, a fundamental trader will analyze certain factors, or fundamentals, which impact the currency’s host country to draw a picture as to how the currency will behave. These factors include the country’s gross domestic product (GDP), inflation, interest rates, Consumer Price Indices (CPI), Producer Price Indices (PPI), or any other newsworthy items that say something about the economic health of the country.

Like Brexit?

Exactly like Brexit. Whether a Leaver or Remainer, every trader understood that the British pound would be negatively affected by the Brexit saga, because it meant that Britain’s relationship with its biggest trading partner, the European Union, was in jeopardy. That’s why, when the Brexit decision was announced, the pound had its largest fall in thirty years on a single day.

Fundamental traders looked at Brexit and concluded that it was not optimal for the British economy over the near term and sold British pounds before they fell further in value. Even those traders who did not think it detrimental to Britain’s economy knew that other traders would, so they predicted that the pound would fall anyway.

But Brexit is just one (exaggerated) example of one of the factors that fundamental traders examine when analyzing the markets. When the US Federal Reserve releases its meeting minutes, fundamental traders will enter trades and the US dollar will jump or fall. When the European Central Bank’s governor makes a statement, fundamental traders will trade the euro based not only on what was said, but on what was not said and what they think was said.

Usually, a trader will be a student of one of the above disciplines, or sometimes both. But even technical traders might glance at an economic calendar, which shows the expected economic releases for that week, such as central bank meetings, CPI/PPI releases, etc. This can give you a general idea of what might be moving the markets soon, so you’re prepared and not caught off guard by unexpected price movements.

Now that you’re more equipped to answer the question of “What is Forex?” we should talk about how to get started trading Forex.

How to Get Started in Forex

To start trading Forex, you need to do the following:

  1. Take your time to study the markets and learn about Forex trading so that you feel comfortable and ready to start.

  2. Decide whether you prefer to use fundamental analysis or technical analysis, or both.

  3. Decide how much money you need to start Forex trading and are willing to deposit in your trading account. You should only risk money you can afford to lose.

  4. Now it’s time to find the best Forex broker for you. The Forex broker processes all your trades, provides you with trading tools, such as trading platforms and live quotes, sets the spreads and fees and pays you your profits (or debits your losses).

How do I choose the right Forex broker?

Luckily for you, we have reviewed hundreds of different Forex brokers.

One vital thing to look for in a Forex broker is a demo account. A demo account is what you’ll use to practice trading Forex without risking your actual money. You’ll be given virtual currency by the broker to use for your Forex “trading” in the demo account, and you’ll be able to not just learn about trading on the job, but also explore the trading platform and overall environment that the broker offers.

It’s a lot like that project in high school where you had to carry around an egg for a week, so you’ll know what it’s like to take care of a baby.

All I learned from that is that egg yolk is hard to wipe off the floor.

That’s my next point. It’s impossible to overstate the psychological impact that real life has on your decisions. Trading with a demo account is a fantastic learning tool, but it’s a very different ballgame when it’s your money on the line.

Speaking of your money, let’s talk about one more thing that will be a crucial consideration in assessing a broker, and something that can really impact your success or failure: leverage.

What is Leverage in Forex?

Using leverage is like falling in love: it’s exciting and it’s dangerous.

 Leverage is money that the broker loans you to place trades. You’ll have to pay the broker back that leverage, whether you profit or lose from the trade. The broker will require you to have a certain amount of your own capital in your account, called margin, which will determine how much leverage you can use.

Here’s how it works:

Say you want to trade the AUD/USD and you have $100 margin in your account. The maximum leverage, the broker tells you, is 10:1. This means that you have $1,000 to trade. In Forex lingo, we call that a micro lot, where 1 lot equals $100,000 and 1 micro-lot equals 0.01 lots, or $1,000.

There are two main factors that will determine the maximum leverage offered by a broker:

  1. Regulation – many countries require Forex brokers to be licensed to operate legally, and their laws will require regulated Forex brokers to offer no more than a certain maximum leverage. In the Eurozone, for example, the European Securities and Market Authority (ESMA) does not permit regulated Forex brokers to offer more than 30:1 leverage. Similarly, in Australia, the Australian Securities and Investment Commission (ASIC) caps leverage at 30:1. The primary justification for this is to try to ensure that new traders, who can be known to be ambitious and over-confident, don’t overreach and lose too much money.

  2. Volatility - the more volatile a currency or asset, the less leverage the broker will offer. For example, Bitcoin has fluctuated by more than 10% in a single day on several occasions, so brokers will offer much lower leverage on Bitcoin than they typically will on currencies which tend to fluctuate by much less such as the US Dollar or Euro.

This seems like a good time to lay out the pros and cons of Forex trading, just so you can have a snapshot of the lifestyle.

Pros:

  • While other markets are cost-prohibitive, you can trade the Forex market with as little as $5.

  • You can trade the Forex market anywhere, anytime during the week, if you have an internet connection and a brokerage account.

  • Even if your account size is small, you can make larger trades with leverage.

  • There is high liquidity, meaning that there are a lot of people and institutions trading Forex at any given time. This means that even when things get volatile, prices are less likely to suddenly jump or fall as dramatically as other markets.

  • The fact the Forex market is de-centralized helps curb volatility, as it isn’t as easy to surprise the market with sudden things like new regulations. It also allows you to place short trades, which is prohibited in some other markets.

Cons:

  • The Forex market can be very high risk, especially if you’re using leverage. It’s a known industry statistic that between 70%-80% of Forex traders lose money in the European Union.

  • With no regulator to enforce certain business practices, transparency in the Forex market isn’t a sure thing. The best way to make sure you have transparency when it comes to Forex trading is by trading with a well-regulated broker.

  • You really must educate yourself, because while brokers in other markets can coach you on what and how to trade, that’s not a service you can expect to get in a dedicated way from any Forex broker.

Final Thoughts

If you’ve ever seen the hit sitcom Friends, you might remember when Joey tries to learn guitar from his eccentric friend, Phoebe, who has a very unorthodox approach. Phoebe insists that Joey first learn the hand positions for the chords before actually playing the guitar. When she catches Joey trying to learn with a guitar, Phoebe chides him: “Do you want to learn to play guitar? Then don’t touch one!”

While this is obviously a funny approach to learning an instrument, it’s a smart approach to learning to trade Forex. Remember the trading trifecta we mentioned in the beginning? Now that you know the answer to “What is Forex?” it’s important that you devote real time and energy to learning before you trade with real money.

Don’t forget, this article is just the hors d’oeuvres. There are many more resources out there, like FXacademy.com, to help you make the crème brûlée.

FAQs

What is Forex and how does it work?

Forex is a portmanteau of “foreign exchange,” which is the exchange of currencies. You can buy and sell currencies for speculation through a Forex broker.

Can you get rich by trading Forex?

You can, but it takes time, patience, mental fortitude, practice, wise spending, and a lot of learning.

Is Forex a pyramid scheme?

No. You do not need to involve anyone else to trade Forex, so it is not a pyramid scheme.

Gabriel Sherman
Gabriel joined the team at DailyForex in 2020. Gabriel had previously worked as the national sales manager for a payment processing company, where he edited the marketing materials. After obtaining a degree in Communications from the Interdisciplinary Center of Herzliya, Gabriel helped mortgage and insurance brokers and fintech companies become authorized by the Financial Conduct Authority, and edited the company website and documents.

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