What is forex trading and how does it work?

What is forex trading and how does it work?

In this guide you will learn everything you need to know about the foreign exchange market, the world’s largest financial market. And then we will talk about Forex trading, the most popular way to speculate on the movements of different currency pairs in order to make a profit.

What is Forex?

FOREX is the global currency market and corresponds to the abbreviation of the English term Foreing Exchange, which can be translated as “foreign exchange”.

It is also known under a number of other names such as FX, forex market or foreign exchange market.

In the foreign exchange market, one currency is exchanged for another, such as the euro (EUR) against the dollar (USD).

Here is a practical example of the foreign exchange market:

Let’s say we want to travel to another country in the world that has a different currency than ours. Before we start our journey, we go to our bank and exchange our currency (e.g. euro) against the currency of the country we are going to travel to (dollar, yen, pound…).

In this way, we have participated in the foreign exchange market and exchanged one currency for another at a certain rate.

You will often see the terms FX, Forex and forex market. All these terms are synonymous and refer to the foreign exchange market.

Who participates in the foreign exchange market?

Given the large size of the foreign exchange market, you may wonder: who are the participants in the foreign exchange market?

We can group them into three main groups:

‘banks’ means either central banks, commercial banks or investment banks;

Large companies: They may participate in the foreign exchange market to invest directly in foreign currency or to secure their investment portfolio, just to name a few examples.

Individuals or small businesses: any person, inter alia, for the purpose of trading or making purchases from an online store in another country; This group also includes small entrepreneurs, brokers, etc.

What is Foreign Exchange Trading?

Foreign exchange trading consists of speculating on the price fluctuations of the currency pair in order to make an economic profit on the difference between the bid and ask rates.

For example, a forex trader may buy US dollars (and sell their euros) if they believe that the value of the dollar will rise and therefore its price will rise. This is done by trading currency pairs and is explained below.

Currency for Forex Trading

A currency is a foreign currency, that is, a different official currency than your own country.

Each country or region has its own currency, and one way to determine its value is to compare it with the currencies of other countries. For example, if we want to know what a euro is worth, we can compare it to the dollar.

This is called currency pairs or currency pair crosses.

For example, the Euro/Dollar (EUR/USD) currency pair means we compare the value of a euro with the value of a dollar.

There are a large number of currency pairs or crosses, which are often divided into large, smaller and exotic currency pairs.

Major currency pairs are the most traded and have the highest liquidity:

EUR/USD: Euro vs. US Dollar

GBP/USD: Pound Sterling vs. US Dollar

AUD/USD: Australian Dollar vs. US Dollar

NZD/USD: New Zealand Dollar vs. US Dollar

USD/CAD: US Dollar vs. Canadian Dollar

USD/JPY: US Dollar vs Japanese Yen

Unimportant pairs are traded less frequently and have lower liquidity. Some examples are:

EUR/JPY: Euro vs. Yen

AUD/NZD: Australian Dollar vs New Zealand Dollar

EUR/GBP: Euro against pound sterling

EUR/CHF: Euro vs Swiss Franc

Finally, there are the exotic pairs, which are crosses between a major currency and another currency in a small country or emerging market. They are rarely traded, such as USD/MXN (Dollar vs. Mexican Dollar) or EUR/TRY (Euro vs. Turkish Lira).

How forex trading works

In forex trading, it is possible to make money on both rising and falling currencies. This is called “long” or “short” trading.

In long trading, you buy a currency pair if you think the base currency will rise in value and therefore become more expensive to sell.

Let’s look at a long trade with the currency pair USD/JPY (US Dollar/Yen):

When trading cards, we speculate that the price of a currency pair will fall. To do this, we first sell and then buy back when the price has fallen.

In the following example, we see a short trade with the USD/CAD (US Dollar/Canadian Dollar) currency pair:

The short trade can be a bit confusing, but just remember that we make a profit when there is a difference between the entry price (above) and the price at which we close the trade (below).

Fundamentals of Forex Trading

Now let’s look at some of the basics of forex trading that you should know.

How to read a currency pair

A currency pair is divided into the base currency and the offer currency.

EUR (Euro) is the base currency or the first currency we exchange for dollars.

USD (dollar) is the so-called quotation currency or second currency.

Price: is the exchange rate

The price of a currency pair is usually expressed in a form similar to this:

EUR/USD 1.22

The figure to the right is the exchange rate, which expresses how many units of one currency are needed to get one unit of the other.

What does this mean for the example above EUR/USD 1.22? This means that for 1 EURO we would get 1.22 DOLLARS.

Why is the currency market moving?

Forex pairs move due to various factors affecting currencies. Among the most important are:

Economic data: Currencies supported by strong economies are in high demand. Some important economic data that may influence currency prices are inflation or unemployment figures.

Central banks: They set interest rates and influence money flows.

Political reasons: Political uncertainty in some countries causes demand for certain currencies to fall and money to flow into safer markets such as the Swiss franc or the US dollar.

Foreign exchange market opening hours

The opening hours of the foreign exchange market are very long. It is open 5 days a week, 24 hours a day. It opens on Monday morning Australian time and closes on Friday night at the closing of the US market.

Every day there are 4 sessions corresponding to each of the major world markets.

London

New York

Sydney

Tokyo

Basic Foreign Exchange Trading Conditions

The best way to better understand forex trading is to learn its language. Here are some terms to get you started.

Forex Brokers

A broker is an intermediary company that allows us to trade on the foreign exchange market.

Ask price and BID price

When you look at the price of a currency pair at the broker, you will see two different prices: the ASK price and the BID price. The ASK price is the price you have to pay when you buy and the BID price is the price you have to pay when you sell.

What is the spread?

The BID price is always lower than the ASK price and the difference is called SPREAD, which is the cost of the trade.

Simply put, the spread in forex trading is the money a broker takes out to execute your trades.

What is a PIP?

Currency pairs move in small increments. The minimum value of these steps is called a PIP in forex trading.

Lots

Much on Forex is the unit of measurement used when buying or selling a pair and is equal to one hundred thousand units of the base currency.

There are also smaller units such as the mini-lot and the micro-lot.

Influence

When trading on the Forex market, we have the opportunity to leverage and borrow money.
Borrow money. This allows you to trade with more money and make more profits (but also more losses).

Marginal

Margin is related to leverage, as it is the amount of initial deposit you need to make to open and hold a leverage position.

Why do people trade currency?

Let’s go over some of the reasons why people trade currency, and some of the reasons why others prefer to stay away from this market.

Advantages:

It is the most traded market in the world on a daily basis, so it is easy to enter and leave a position in most currencies. Therefore, it is known as a very liquid market.

The Forex market has very long opening hours and makes it easy to adapt your trading to your lifestyle. For example, if we have an 8-hour job, we can customize our way of shopping accordingly.

You can start with a little capital and increase it when you get more solid results.

Disadvantage:

One must pay close attention to the different news and events, as they may lead to a sharp increase in volatility.

The leverage that brokers allow can play a trick on us if we do not have much experience.

The Forex market is much more volatile than other markets such as the stock market.

How to trade with foreign currency

You can use a variety of financial products to trade currency. Some examples are:

Spot Forex

CFDs

Futures contracts

alternative

ETFs and ETNs

The easiest way to trade in the foreign exchange market is through a CFD broker, which is the most common way to trade for retail clients.

To put it simply, to trade on the foreign exchange market, you need to do the following:

  1. Open an account with a broker.
    An account with a broker is always required to trade the different currency pairs and place buy and sell orders.

2. Analyse the market for opportunities
When analyzing a currency pair to know when to buy or sell, the two most common methods are:

Technical Analysis

Technical Analysis focuses on analyzing price and volume using charts. Using this analysis, we try to determine which price movement is most likely to make a profit.

Basic analysis

Fundamental analysis in the foreign exchange market focuses on analyzing economic, social and political information to determine whether this information will weaken or strengthen a currency and therefore whether its price will rise or fall.

3. The use of market observation and analysis tools.
There are a number of market analysis tools that we should be familiar with.

For example, for technical analysis we use programs such as Metatrader or Tradingview.

And to monitor the most important news affecting currencies, we can access sites like Forex Factory.

4. Develop a strategy and a trading plan
Trading strategies involve analyzing the market to determine the best entry and exit points, as well as the size of the position and how long it should be opened.

Strategies often include elements of different analytical methods and a variety of tools that try to predict future market movements.

The strategy depends on your trading style. The main types of trading are: Scalping, Day trading, Swing trading and Positional trading.

Depending on our trading style and strategy, we need to make a trading plan with a set of rules that tell us how we will enter and exit the market, manage our positions and control the risk of trading, among other things.

And here ends this article, where I have tried to explain as briefly as possible what Forex trading is and how it works.

If you want to delve deeper into the ideas we have seen, continue with the following lessons of the free Forex course.

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