• Home
  •   >  
  • What is Forex Trading

What is Forex Trading?

The forex market is the largest and most liquid market in the world. The average daily trading volume in the forex market is roughly $6.6 trillion. The impact of the forex market is also highly significant. Price movements in the forex market can decide the cost of grocery in Poland to the cost of a pint of beer in Malaysia.
Forex trading has been gaining in popularity around the world. Earlier, forex trading was only conducted by large banks, governments, and financial institutions. However, nowadays, forex trading is also available to ‘retail’ traders or individual traders who would like to participate in the forex market.

Here is a short guide to forex trading that will help you understand what it’s about and how it’s done.

The Basics of Forex Trading

Forex is also known as foreign exchange or currency exchange. Forex trading refers to the buying and selling of currencies. For example, if you buy US dollars and sell British pounds, then it is forex trading.

To understand forex, you may think of the currency exchange that you do when you travel abroad. You will need to buy the foreign currency to be able to travel in that country. This is called currency trading.

The exchange rate between currencies fluctuate depending on the demand and supply. For example, if lots of people are buying Indian rupees, then the relative price of the Indian rupee goes up. Similarly, if lots of people are selling Russian roubles, then the relative price of the Russian rouble goes down.

The main objective of forex trading is to take advantage of these price fluctuations to make money. You can buy a currency at a cheaper valuation to be able to sell it at a higher valuation. Or you can sell a particular currency at a higher valuation and then buy it for cheaper. The difference is your profit.

Currencies are traded in the global market. This global market is open 24 hours a day on all weekdays. You can buy or sell currency at any time during these days. All currencies are traded over-the-counter (OTC). This means that there is no physical exchange of money.

The exchange is conducted by a global network of banks. This is different from the stock market which is overseen by a central exchange such as the New York Stock Exchange (NYSE).

Most of the volume in forex trading comes from institutional traders. These are traders acting for large banks, governments, fund managers, and multinational corporations. However, the volume belonging to retail or individual traders is slowly increasing.

How Does it Work?

Forex trading involves buying one currency and selling another. This is why forex is quoted in pairs. For example, the EURUSD is a currency pair. The first part of the pair, which is the EUR in this example, is the base currency. The second part of the pair, which is the USD, is called the quote currency.

All currencies are represented by their three-letter code. For example, the code of the British pound is the GBP. A trader needs to know the three-letter code of the currency pairs that they intend to trade.
Traders are concerned with the relative pricing of each currency pair. For example, while writing this guide, the EURUSD was trading at 1.21. This means that one EUR is worth 1.21 USD. If the relative price of the EURUSD goes up, it means that the EUR is gaining in value. If the relative price of the EURUSD pair goes down, it means that the USD is gaining in value.

If a trader thinks that the value of the EUR is going to rise, then they will buy the pair (called “going long”) while if they think that the value of the EUR is going to fall, then they can sell the pair (called “going short”).
For easy reference, currency pairs are divided into four major types. Forex brokers refer to these major types as “major pairs”, “minor pairs”, “exotic pairs”, and “regional pairs”. The major pairs are the seven different currencies that are responsible for 80% of the global forex trading volume. These trading pairs include the EURUSD, USDJPY, USDCAN, and so on.

In order to participate in the global forex market, a retail trader needs to sign up or register with a forex broker. There are hundreds of forex brokers in the world each with their own pros and cons. A trader should research different forex brokers and sign up with one that suits their needs best.

A trader should ensure that the forex broker is safe to trade through, they provide good customer support, they charge affordable fees, and they provide the relevant trading instruments which the trader wants.

The Risks Involved in Forex Trading

Participating in the forex market is inherently risky. Currency pairs are highly volatile. They change in value quickly. Hence, a trader can easily lose money if they make a wrong trade. For example, if a trader goes long on the EURUSD currency pair, but the value of the EUR falls, then the trader will make a loss.

The loss that a trader may face is compounded by “leverage”. A large part of forex trading is conducted through leveraged products. This allows very high value trades to be conducted at a fraction of the cost. For example, a typical leverage offered by forex brokers for currency pairs is 1:500. This means that a trader can open a trade worth 500 times more than the money he has invested.

The problem with leverage is that it increases the risk associated with the trade. A trader can lose a large amount of money in a very short amount of time because of leverage. The possibility of profit is equally high, which is why leverage is used.

There are several risk management techniques that a forex trader can use in order to limit or manage the risk. For example, a trader should only register with a broker that offers “negative balance protection”. This means that the trader can only lose the money that he has deposited in his trading account and not more.
Other risk management techniques include “stop-loss”, trading with lower leverage, and so on.

Ways in Which Forex is Traded

Most trades in the forex market are not made in order to exchange currency. They are conducted in order to profit from the future price movements of those currencies. This is different from exchanging money in order to travel to a foreign country.
Since most forex trades are made for speculative purposes, there is no need to exchange the actual currency. Hence, these trades are conducted “over-the-counter”. In this way, forex trading is similar to stock trading.

There are three primary ways in which forex trading is done.

Spot market– This is also the main forex market. In this market, currency pairs are swapped and the exchange rate is calculated in real-time. The exchange rate is determined by demand and supply, as mentioned earlier.

Forward market– Rather than execute the trade in real-time, a trader can enter into an agreement with another trader with speculative exchange rate for the currency pair at a later date.

Futures market– Traders can also opt for standardized contracts to exchange currency at a later date. This is done through exchanges rather than through a private contract. The difference in price from the current date to the future date will determine the quantum of profit or loss.

The forward and futures markets were created in order to allow participants to hedge against the risk of future price fluctuations. Nowadays, they are primarily used to speculate on the price movements in the currency market.

The exchange rate provided in the forward and futures markets depend on the price fluctuations in the spot market. The spot market shows the real-time price of any currency, while the futures and forward markets are based on contracts.

Price Movements in Forex Trading

Currencies are highly volatile instruments. The forex market is made up of currencies from around the world, and a variety of factors can affect price movements. It is highly difficult to predict these price movements with any consistency.

Similar to most financial markets, the currency market is also driven by supply and demand. This means that the price of a currency goes up if demand is high and it goes down if there is more supply.
There are many forces which determine the supply and demand in the forex market. Some of these are noted below.

Central Bank policy – The supply of any currency is controlled by the central bank of that country. For example, the Federal Reserve determines the supply of USD in the global market. If the central banks want to increase the valuation of their currency, they can reduce the supply, and vice versa.

Central bank policy is determined by a large number of factors including inflation, economic condition, export and import, and so on.

Current news– The news reports relating to the outlook of a country also determines the value of their currency. For example, if there is positive news coming out of Malaysia with regard to investments in the country, it will lead to a higher demand for their currency.

If there is negative news, then the demand for that currency will fall. For example, political instability is one of the leading causes for a country’s currency to go down. Similarly, strong investment opportunities may lead to a country’s country to go up.

Market sentiment– The public perception relating to the price movements of a currency can affect the price as well. For example, if the global public feels that the USD is going to go up, then it is likely that the demand for USD goes up leading to an increase in price.

The market sentiment is governed by a variety of factors including the reaction to news, comments by influencers, and so on.

Economic data– Economic data coming out of a country plays a large role in determining the price of its currency. The economic data provides an indication of how well an economy is performing and also provides insight into the behaviour of the central bank of that country.

Final Thoughts

Forex trading can lead to high profits for successful traders, however there is a large amount of risk involved. Before starting to trade in the forex markets, traders should conduct thorough research and understand the markets. Traders should also be careful in choosing their broker and make sure that their money is safe. We hope that you have found this guide helpful.