In this article you will learn: What is forex trading and how does it work and and many other things about this largest market in the world.
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What is Forex
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.
Quite simply, Forex is the global financial market that allows one to trade currencies. If you think one currency will be stronger versus the other, and you end up correct, then you can make a profit.
How big is it?
Forex is the largest financial market in the world.
Compared to the “measly” $22.4 billion per day volume of the New York Stock Exchange (NYSE), the foreign exchange market looks absolutely ginormous with its $6.6 TRILLION a day trade volume.
The largest stock market in the world, the New York Stock Exchange (NYSE), trades a volume of about $22.4 billion each day.
Forex trading time
The forex market is open 24 hours a day and 5 days a week, only closing down during the weekend. (What a bunch of slackers!)
So unlike the stock or bond markets, the forex market does NOT close at the end of each business day.
Instead, trading just shifts to different financial centers around the world.
How does forex trading work?
In forex trading, currencies are always traded in pairs, called ‘currency pairs’. That’s because whenever you buy one currency, you simultaneously sell the other one.
Each currency pair is made up of two parts:
- Base currency: the first currency listed in the quote and always equal to 1
- Quote currency: the second currency listed in the quote
For example, let’s take a look at this currency pair:
GBP/EUR = 1.01250
Here, the base currency is GBP (pound sterling) and the quote currency is EUR (euros). This means that £1 is worth 1.17 euros if you wanted to buy.
Currencies are traded online through a forex broker. The forex market is open 24-hours a day from Sunday night to Friday evening.
When you buy a currency pair, the price you pay is called the ‘ask’ and when you sell, the price is called a ‘bid’. This price for the same currency pair will be slightly different depending on whether you are buying or selling.
These can be a little confusing to get your head around at first. But it helps to remember that prices are always listed from the forex broker’s perspective rather than your own.
In the eyes of a broker, potential buyers have to place a bid when you sell a currency. And you’ll have to pay the seller’s asking price when you buy a currency.
How Currencies Are Traded
All currencies are assigned a three-letter code much like a stock’s ticker symbol. While there are more than 170 currencies worldwide, the U.S. dollar is involved in a vast majority of forex trading, so it’s especially helpful to know its code: USD. The second most popular currency in the forex market is the euro, the currency accepted in 19 countries in the European Union (code: EUR).
Other major currencies, in order of popularity, are: the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF) and the New Zealand dollar (NZD).
All forex trading is expressed as a combination of the two currencies being exchanged. The following seven currency pairs—what are known as the majors—account for about 75% of trading in the forex market:
How Forex Trades Are Quoted
Each currency pair represents the current exchange rate for the two currencies. Here’s how to interpret that information, using EUR/USD—or the euro-to-dollar exchange rate—as an example:
- The currency on the left (the euro) is the base currency.
- The currency on the right (the U.S. dollar) is the quote currency.
- The exchange rate represents how much of the quote currency is needed to buy 1 unit of the base currency. As a result, the base currency is always expressed as 1 unit while the quote currency varies based on the current market and how much is needed to buy 1 unit of the base currency.
- If the EUR/USD exchange rate is 1.2, that means €1 will buy $1.20 (or, put another way, it will cost $1.20 to buy €1).
- When the exchange rate rises, that means the base currency has risen in value relative to the quote currency (because €1 will buy more U.S. dollars) and conversely, if the exchange rate falls, that means the base currency has fallen in value.
A quick note: Currency pairs are usually presented with the base currency first and the quote currency second, though there’s historical convention for how some currency pairs are expressed. For example, USD to EUR conversions are listed as EUR/USD, but not USD/EUR.
Three Ways to Trade Forex
Most forex trades aren’t made for the purpose of exchanging currencies (as you might at a currency exchange while traveling) but rather to speculate about future price movements, much like you would with stock trading. Similar to stock traders, forex traders are attempting to buy currencies whose values they think will increase relative to other currencies or to get rid of currencies whose purchasing power they anticipate will decrease.
There are three different ways to trade forex, which will accommodate traders with varying goals:
- The spot market. This is the primary forex market where those currency pairs are swapped and exchange rates are determined in real-time, based on supply and demand.
- The forward market. Instead of executing a trade now, forex traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed upon amount of currency on a future date.
- The futures market. Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.
The forward and futures markets are primarily used by forex traders who want to speculate or hedge against future price changes in a currency. The exchange rates in these markets are based on what’s happening in the spot market, which is the largest of the forex markets and is where a majority of forex trades are executed.
How to Start Trading Forex
Trading forex is similar to equity trading. Here are some steps to get yourself started on the forex trading journey.
1. Learn about forex: While it is not complicated, forex trading is a project of its own and requires specialized knowledge. For example, the leverage ratio for forex trades is higher than for equities, and the drivers for currency price movement are different from those for equity markets. There are several online courses available for beginners that teach the ins and outs of forex trading.
2. Set up a brokerage account: You will need a forex trading account at a brokerage to get started with forex trading. Forex brokers do not charge commissions. Instead, they make money through spreads (also known as pips) between the buying and selling prices.
For beginner traders, it is a good idea to set up a micro forex trading account with low capital requirements. Such accounts have variable trading limits and allow brokers to limit their trades to amounts as low as 1,000 units of a currency. For context, a standard account lot is equal to 100,000 currency units. A micro forex account will help you become more comfortable with forex trading and determine your trading style.
3. Develop a trading strategy: While it is not always possible to predict and time market movement, having a trading strategy will help you set broad guidelines and a road map for trading. A good trading strategy is based on the reality of your situation and finances. It takes into account the amount of cash that you are willing to put up for trading and, correspondingly, the amount of risk that you can tolerate without getting burned out of your position. Remember, forex trading is mostly a high-leverage environment. But it also offers more rewards to those who are willing to take the risk.
4. Always be on top of your numbers: Once you begin trading, always check your positions at the end of the day. Most trading software already provides a daily accounting of trades. Make sure that you do not have any pending positions to be filled out and that you have sufficient cash in your account to make future trades.
5. Cultivate emotional equilibrium: Beginner forex trading is fraught with emotional roller coasters and unanswered questions. Should you have held onto your position a bit longer for more profits? How did you miss that report about low gross domestic product (GDP) numbers that led to a decline in overall value of your portfolio? Obsessing over such unanswered questions can lead you down a path of confusion. That is why it is important to not get carried away by your trading positions and cultivate emotional equilibrium across profits and losses. Be disciplined about closing out your positions when necessary.