What is forex trading and how does it work?

Forex trading, also known as foreign currency exchange or simply FX trading, involves transactions of exchanging currencies in hopes of making a profit through price changes caused by supply and demand. In 2019, it was reported that the forex exchange market had a daily trade volume of more than 6 trillion dollars. It is the biggest and most liquid market in the world because of the need to exchange national currencies when dealing with commerce and finance. 

Forex trading has existed for centuries but required the exchange of currencies and goods between different countries. Before the Internet became a world staple, only institutions, such as hedge funds, conglomerates, or multi-millionaires, had access to this because of the high capital requirement and high commission cost. 

Through technological development, a commission of some brokers reaches as low as zero, and some even allow the use of high leverage for clients that would want to exponentially increase their gains. Currently, it is the most accessible market, given that most if not all countries allow forex brokers and traders to participate in this opportunity.

All trades go through a network of banks together with market makers and liquidity providers to ensure that you get accurate prices and updates on all your investments. With proper regulation, investing in forex is very safe and reliable as long as the investor chooses a verified, certified, and regulated broker. 

Foreign currency exchange always involves two currencies that are traded against each other. Each currency is listed as a three-letter code that is usually used to identify its country of origin and the name of the currency itself. For example, the USD is the code for the dollar of the United States, while the GBP stands for the pound sterling of Great Britain. 

There are hundreds of these currency pairs, and these could be traded simultaneously as long as the market is open. There’s more than one way to profit from this, and these methods would be discussed later on. 

Together with the development of investment platforms, brokers and banks now provide derivatives when trading forex. Unlike before, when people could only trade vanilla forex pairs, now, traders can also opt to avail the use of margin and leverage when trading options, futures, offering forwards, and currency swaps. 

Forex traders can use this asset class as a main source of income when trading, or they could use forex as a hedging strategy during bad market conditions. This opens up unlimited ways to utilize this asset class, such as for diversification purposes or even for speculation on market-moving news. 

The different types of forex or currency pairs 

There are three different types of forex or currency pairs. It’s important for forex traders to know the difference between these currency pairs and what features they have to offer. 

#1. Major forex pairs

All in all, there are seven major currency pairs. These are NZD/USD, USD/CAD, AUD/USD, USD/CHF, GBP/USD, USD/JPY, and EUR/USD. These seven pairs make up 80% of the total traded volume of all forex traders. 

The great thing about trading major forex pairs is they offer high volatility. This means this particular asset experiences more movement. This opens more opportunities to major currency forex traders since it doesn’t stay at a certain price for a long time. 

Another feature offers high liquidity. The reason for its high liquidity is because these are all paired with the US Dollar, which is known for being the most traded currency. This attracts more trading volume, which means there are more buyers and sellers on the market. High liquidity also ensures that there will be no shortage of these currency pairs. 

#2: Minor forex pairs

One way to determine whether a currency pair is minor is to check if it is paired with the US Dollar. If the USD is not present, it is considered a minor currency pair. Examples of this type of pair are GBP/CAD, NZD/JPY, CHF/JPY, GBP/JPY, EUR/AUD, and EUR/GBP. 

Although these minor currencies are not paired with the US Dollar, they are still paired with other major currency pairs like the GBP, EUR, AUD, and CAD. However, it only offers moderate liquidity. Additionally, it only offers moderate volatility. 

#3: Exotic forex pairs

Exotic forex pairs consist of a currency from an emerging or developing market and a major forex pair. Examples of exotic currencies are ZAR, TRY, NOK, THB, MXN, RUB. Exotic forex pairs may also come in the form of an exotic currency paired with another like TRY/RUB or NOK/TRY.

This type of forex pair offers low liquidity since it is not as popular as currencies paired with the US Dollar. Exotic pairs don’t attract enough attention. Therefore there are only a few buyers and sellers of this asset. 

However, exotic forex pairs feature high volatility. This is because of the inconsistent economic conditions of the developing market and low liquidity. 

How does forex trading work? 

Generally, when trading forex, you would exchange a currency for another in hopes that the value of your newly acquired currency increases relative to the currency you exchanged. To understand how forex trading works, you should also know how each forex pair is quoted. 

A guide on how to read and interpret forex pairs will be written down below. Subsequently, we will also talk about how to trade these pairs like professional traders. 

Unlike local market exchanges, the foreign currency exchange market functions 24 hours a day because of multiple financial centers around the world. These financial centers that function for five and a half days per week are located in Zurich, Sydney, Tokyo, Singapore, Paris, New York, Hong Kong, London, and Frankfurt to cover all time zones to ensure a continuous market throughout the trading week. 

Although forex trades can be made even when a currency’s local market is closed, it is advisable to trade only when the local market is open for better liquidity and volatility. Traders may also opt to hold their positions overnight or over the weekend, but they should be prepared for unexpected price changes that might arise due to impulsive news. 

Also, with how forex works, transactions only go through on exchanges, but traders do not directly deal with them. Instead, executed trades are directed between two parties that are executing a trade for the same forex pair. These trades all happen electronically in an over-the-counter market which is a decentralized market since there is no central exchange. 

Even though the forex market is liquid, most traders only choose to trade the major and minor or cross currency pairs as these provide the best spreads and would cost the least commission. Trading with high volume on exotic pairs or pairs that don’t have much participation is risky and would pose an extra risk for the trader. 

Like other asset classes, you can pre-set your orders in advance to prepare you when a certain asset reaches your target price. There are also different order types that you can choose from to further improve your trading strategies.

The different types of forex markets 

#1. Futures currency market

When trading in the future’s currency market, you will basically be setting up a trade that will be executed in the future. You can select a futures contract based on the available dates with your ideal timeframe in mind. Once the contract expires, it will automatically execute the trade even if it did not reach your set price. 

#2. Forward currency market

Forward contracts function almost the same as futures contracts. In this market, however, you can specify the expiration dates for your contract as you execute these in the market. Additionally, forward currency markets do not exist on a centralized exchange. Instead, they are traded on the over-the-counter market.

#3. Spot currency market

The spot currency market is the standard market wherein Forex trades occur. As the term suggests, you will be executing trades based on the spot price of every forex asset that your broker offers. You will be able to close your positions at any time as well, unlike futures contracts and forward contracts. Additionally, derivatives involving the spot currency market also follow the same market conditions. 

How does leverage work when trading forex? 

Although leverage can be used for a lot of different asset classes, it is especially important in forex with how minuscule forex pairs move in value. Most, if not all, traders suggest using leverage to increase the amount of gain they receive out of a successful trade. Using leverage together with margin is a necessity for forex traders that do not have millions in their account. 

Leverage allows traders to avail of more exposure to a certain asset by just paying a fraction of the cost. The trade-off for this higher profit return is higher risk. When availing of a leverage then increases your probable gain by 20 times, you would also incur a risk equal to 20 times as well. Through this borrowed capital, traders will boost their profitability but must manage their funds so that they will not lose out a lot of money if they are wrong. 

For example, if you want to enter a trade worth $10,000 but you only have $1,000, you would avail of a leverage of 10x. This, however, would also increase your risk by 10x, and your position would be automatically closed if you lose $1,000, which is just a 10% drop of $10,000. 

This significant loss should be managed by decreasing your risk tolerance by diversification through lesser portfolio allocation, or traders may also tighten their stop losses. Some might have experienced blowing up their account or losing all of their capital, but that’s because they are just excited about the potential profits they would gain without taking account of the potential losses they might incur. 

Even when using leverage, traders do not need to wait for assets to reach their target points for taking profits or cutting losses, but instead, they could opt to close their trade early if they think it’s the best decision. Subsequently, other brokers allow changing the leverage rate of their open positions. 

There are also different kinds of leveraged products which traders can use to their advantage. One is Spread Betting, and the other is CFDs. 

Spread betting is popular in the United Kingdom and involves betting on the direction of the price movement of the trade. For example, if you bet that the forex pair GBP/USD would go up, you would earn money if the asset went up in value. Furthermore, traders will earn more money the higher it goes. 

CFDs or Contracts for difference are a derivative of common asset classes that allow clients to earn depending on the price movement of your invested asset. Having a CFD of a forex pair does not mean that you own that forex pair. But instead, you just earn or lose money from the difference between your buying price and the closing price of your position. 

How does margin work when trading forex? 

Margin works hand-in-hand with leveraged trading. To use added capital, you need to offer up margin requirements that act as collateral. 

Your margin requirement and the margin you can use will depend on your broker and the type of account you are using. Sometimes, different assets on the same broker would have varying margin requirements because of volatility and liquidity factors. 

Usually, the margin requirement is listed in percentage points. For example, if GBP/USD requires a 1% margin, you would need to have $1,000 USD to use $100,000 worth of funds for GBP/USD.

Remember that the margin requirement is set aside and can’t be used for other transactions even within the broker. If you go below a certain amount, you will experience what is known as a margin call. 

When you receive a notice for a margin call, you are required to add more funds to your account, or you could also liquidate some of your positions so that your current position using margin would be sustained. If you fail to provide the funds, your broker may automatically force you to close your open positions until the margin requirement is fulfilled. 

What are pips? 

A pip is a minimum amount in which a currency can change. It is a common unit in forex, and you will be sure to encounter this term once you start trading. Pip is an abbreviation for “price interest in point” or for “percentage in point.” 

Generally, one pip is worth 0.0001, one basis point, or 1% of 1/100. The movement of pips allows quick but small trades that should accumulate over time. 

Despite being a small value, once you have multiple trades under your account or trades that cost a lot, you will realize that these pips add up and will have cost you hundreds if not thousands of dollars. That is why a lot of brokers gain customers through advertising that they have low pip spreads. 

Depending on your broker, you might encounter an additional decimal after the number that designates pips. This is called a fractional pip or pipettes. 

A fractional pip is 1/10 the value of a pip and is found in the 5th decimal place in most cases. Having access to this allows better control of your trades since knowing the fractional value will prevent you from entering a trade with very high spreads or would convince you to enter the one that has low spreads. 

As mentioned, most of the time, a pip is found in the 4th decimal place most of the time. This applies to most major, minor and exotic currency pairs. The exception to the rule includes currency pairs that involve JPY. 

To know what a pip is, you need to look at the number beside each forex pair’s currency. If the value for a currency is 1.6184, the pip will be at the 4th decimal place, which is the number 4. With an increase of one pip, the value of the currency will become 1.6184. 

For currency pairs that have JPY, such as EUR/JPY, the pip can be found in the second decimal place. If the value is 103.156, the number 5 on the second decimal place is your pip. An increase of one pip in value will make the currency’s price be 103.166. 

What is a spread? 

 When looking at the bid and ask prices of currency pairs, the spread is the difference between these two, and it acts as a commission when using the services of the broker.

To calculate the spreads, it is beneficial to know what pips are. For example, if the bid price of EUR/CAD is 1.4807 and the asking price is 1.4810, the calculated spread would be three pips.

Brokers would usually compete with each other by offering lower spreads as this significantly reduces costs incurred by traders and would also probably increase their overall gain through multiple trades.

What is a lot? 

 When trading forex, you will be trading in lots instead of shares. Lots are the units of the currency which you will purchase or sell.

Usually, lots are worth 100,000 units of the currency you are trading. However, some brokers offer micro lots and mini lots, which are worth 1,000 and 10,000 units of the currency, respectively.

One hundred thousand units of a currency is a big amount, but with leverage, one could easily reach this value so that they could start trading. With 1,000 dollars, you can start trading one standard lot if you use 100x leverage.

What causes forex prices to move? 

#1. Market Sentiment

Market sentiment is defined as the investors’ collective attitude towards a specific financial or security market. This plays a huge role when it comes to convincing traders to invest in a particular asset. If investors report that a certain forex pair doesn’t show potential for profit, forex traders will opt not to invest in that pair. 

#2. Media reports

Traders and commercial banks prefer to invest their hard-earned capital in economies that have a positive standing. If the media or news reports about a particular region in a positive way, this catches the attention of investors and helps increase the demand for the country’s currency. 

Just like market sentiments, news or media reports inform traders whether or not investing in a region’s currency will merit a positive or negative outcome.

#3. Central Banks

Central banks are responsible for controlling the supply and interest rates of the different currencies. Both of these have a significant effect on the prices and can consequently increase or decrease the demand for affected currencies.

How to trade currency pairs 

 The first step to trading currency pairs has a broker that allows clients to trade forex. Choosing a reputable broker will allow you to save on fees while also having access to the best services offered in the financial market.

The top brokers, according to many, include XM, IG, Saxo Bank, CMC Markets, Interactive Brokers, and TD Ameritrade. Each one has its pros and cons, but the good news is that most of these brokers have a demo account in which you can try out their features during live market conditions.

With multiple options in selecting a broker, you will surely find a broker for you that is legal in your country and has services that you will love. Some of these services include proprietary trading applications, charting software, state-of-the-art interfaces, and research done by their in-house team of professional traders.

Once you’ve selected a forex broker, you need to decide what kind of live account you will want to open. Standard forex accounts allow clients to trade $100,000 with a single lot. Smaller forex accounts include mini forex accounts and micro forex accounts. Both of the smaller forex accounts allow trades of up to $10,000 and $1,000, respectively, per lot.

Alternatively, most brokers would also offer two other types of accounts. These are the demo account, which clients can use to test out strategies and their trading skills using virtual cash and the Islamic account.

The Islamic account is a special type of account that complies with Sharia Law. It is also known as the sharia-compliant finance, and through this account, clients will not be able to earn interest or pay them because of religious practices. Some of the best forex brokers that offer Islamic accounts include Forex.com, Pepperstone, and eToro.

It is important to note that most forex brokers are regulated and are compliant with existing laws that require users to submit or present proof of identification. In creating an account, after providing your email address and password, users are usually asked to also provide their phone number, banking details, identification cards, and billing statements.

These documents help in verifying your account and identity and prevent malpractices such as money laundering or market manipulation. Some brokers would require a phone call when you’re just starting out your account, but most would let you open an account simply by just providing the requirement above.

Clients that have opened a live account, either the standard one or an Islamic account, may now explore their chosen platform, and they may also deposit funds so that they could start trading. It is imperative to either practice first or be familiar with how currency pairs work in general.

If trading is something new to you, you should also learn technical jargon to help you understand what you’re dealing with. Terms such as going long or short, pips, spreads, lots, positions, and many more are just some of the terms that you’ll be dealing with every day.

Understanding how forex pairs are written down is also crucial as trading this asset has differences when compared to simply trading stocks, indices, or commodities. Each currency pair has two currency codes written down, with each code having three letters that signify the currency’s country and the country itself.

For example, when trading EUR/USD, you should immediately be able to identify that you are trading the Euro against the US Dollar. You should also understand that EUR is the base pair while the USD is the quoted-pair.

On the trading platform, values will be listed down either beneath or beside these two different codes. The value nearest to EUR is the amount of money needed to sell 1 Euro, while the value nearest USD is the value you need to buy 1 Euro.

In forex, unlike stocks, you can freely go long or short on any currency pair without any restriction. To go long or bet on the upwards movement of an asset, select it from your broker’s list and simply buy it. On the other hand, when selling the same asset, you are choosing to go short on it.

When going long or short, you need to input important details when making your trade. These important details include the order type, the asset you’re going to buy, the direction of the trade, the number of lots you’re willing to purchase, and the price you’re willing to execute your trade. These details are important factors for you to be successful in your trade. 

For order types, clients can usually set limit orders and market orders that can be customized to trigger immediately or when an asset reaches a certain price. Order types commonly include buy stop, sell stop, buy limit, and sell limit. These order types can be used when executing fresh trades, or they can also be used to trigger future trades that involve taking profits or cutting losses.

Keep in mind that there are different types or classifications of currency pairs as well. As previously discussed, these are categorized as Major pairs, Minor pairs, and Exotic pairs.

As an asset class, currency pairs can be used to profit in two ways. The first one is being able to profit from a change in price or the exchange rate, while the other requires clients to earn from the difference in interest rate from swapping two different currencies.

It is important to note that you can trade forex as derivatives or as regular assets. Trading the derivatives that include CFDs, options, forward contracts, futures, and currency swaps are a bit different and would require different strategies compared to the regular forex assets. 

CFDs function much like the vanilla foreign currency pairs, but the buyer of the long or short position would not be able to own the currency being traded. Instead, the client would be trading against the broker and would profit off of the difference between the opening and closing price of their position.

Options are derivatives wherein a client must predict if an asset’s price would surpass a designated level in the future. Trading options offer more rewards for correct trades but, at the same time, incurs more losses up to the total invested amount if the trade goes wrong.

Forex futures allows clients to exchange their contracts at a specified price in the future determined by the date of the futures contract they purchased. Forward contracts function much like futures contracts, but these are not traded on the exchange but are only transacted in the OTC market or the over-the-counter market.

Currency swaps a derivative that deals with interest rate. The client will exchange a certain amount of an asset with another to hopefully make a profit or lessen their loss from a loan through lower interest rates.

When trading forex without the use of derivatives, it is important to make proper use of margin and leverage. With both of these, you can take advantage of minuscule movements in the market. It is important, however, to temper your greed in using these as these also exemplify your losses and risk incurred.

To locate your setting for margin and leverage, you would need to navigate towards the settings option on your broker, or you could edit it when inputting a trade. The methods of changing either margin and leverage would depend on your broker but, most of the time, you could contact a customer service representative to assist you in this important matter.

Most brokers also charge clients for borrowing money through margin and leverage. Keeping track of this is important since you might be charged fees that you are unaware of. Needless to say, you will be charged a larger amount if you choose a higher value for your leverage.

When trading, it is beneficial if your broker has their own built-in charting software on their platform. Although many free charting software is available online, being able to access one without needing a third-party application saves time. Some of these softwares even offer multiple indicators and allow you to save your charts for future purposes.

When trading stocks, one would usually need a calendar for earnings reports. As for forex traders, there is nothing better than having an economic calendar that is up-to-date with alerts for future economic events.

This economic calendar will not only update you about the happenings in various central banks but will also notify you of non-farm payrolls, unemployment rates, and important speeches by high-ranking officials in government. Being able to avoid or take advantage of these economic events will allow traders to prepare or react to whatever hawkish or dovish sentiment the market has.

Modern online brokers also provide free research materials for clients. These research articles may involve technical analysis or fundamental analysis of various assets. Some may even give recommendations on whether to buy or sell a certain forex pair.

Their well-educated market analysts may also provide their insights on the future movement of prices. Clients do not need to navigate the market on their own anymore since these analysts are always present and may even be available to talk to, depending on the services of your chosen broker.

When trading forex, you can employ different strategies to profit from the market. Although the best forex traders only need a few strategies to be successful, newbie traders need to find their edge in the market by trying out multiple ways to profit, either through a demo account or a live account.

The standard strategy is to swing trade currency pairs. Swing trading involves holding an asset through short-term to medium-term volatility for less than several weeks. Swing traders aim to capture the heart of the move and would only sell when they deem the trade to be reversing in the other direction.

Scalpers are common in trading currency pairs as well. These scalpers aim to profit from immediate moves that the market offers. Likewise, they focus on market-moving news such as earnings reports or monetary policy updates. Since they specialize in this, they only take the most favorable trades and are known to only take a trade after waiting and preparing for the right time.

Long-term investors are more uncommon in this asset class because of how slow forex pairs move. It would be a double-edged sword for them to use a very high level of leverage because of the volatility that forex pairs experience on a day-to-day basis. Their downside risk for overnight trades is a lot higher as well compared to swing traders.

As mentioned earlier, traders can also profit from interest rates of their investments by “carry trading.” If a trader chooses to swap to another currency with a higher interest rate, he will be able to gain a profit out of it. Likewise, a trader may also choose to short a currency with a lower interest rate. 

Why trade forex? 

 Trading forex has a lot of advantages that definitely outweigh its disadvantages. One of the biggest pros is that you can trade forex all day for five and a half days a week. This opens up tons of opportunities in the most liquid market in the world.

Since forex pairs still move during bear markets, choosing to trade this asset class will greatly affect your profitability to earn in the financial market. Being able to spot profitable trades in whatever market will ensure that your portfolio experiences consistent growth.

Most forex brokers are advanced and sophisticated enough to provide top-notch research materials to help even newbies. Having access to this saves traders time in doing their own research and finding profitable trades. Additionally, screeners are also available to easily spot opportunities in the forex market.

With access to high levels of margin and leverage, traders will be able to quickly profit from the market even with the minimum deposit. A series of winning streaks might turn your $100 dollars into thousands if you perform perfectly.

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