What is Forex Trading?
By Stefano Treviso, Updated on: Apr 07 2023.
Forex (FX) trading is the act of exchanging a country’s currency for another. If you have 100 U.S Dollars in your pocket and you change them to Euros, you accomplished a real Forex trade.
Here's what we'll talk about during our guide:
- What is the Forex Market?
- How does Forex trading Work?
- Types of Currency Pairs
- Major Currency Pairs
- Minor Currency Pairs
- Exotic Currency Pairs
- What is Base and Quote in Forex?
- Which are the Forex Market hours?
- Logic Behind the Forex Market
- International Trade
- The Traveller
- The Speculator
- Must Know Forex Terminology
- What is a PIP in Forex?
- A PIP in the Japanese Yen
- Why use PIPs in Forex?
- Leverage in Forex Explained
- How to Calculate Margin in Forex?
- What does Spread means in Forex?
- What is the difference between Forex and Forex CFDs?
- What is Scalping in Forex?
- The Forex (FX) Economic Calendar
- What is the Economic Calendar?
- How does the Forex Economic Calendar usually looks?
- What is the NFP in Forex?
- What Moves Forex Prices?
- Political decisions and major events
- Natural Supply and Demand
- Market Manipulation
- Conclusion
- Frequently Asked Questions
What is the Forex Market?
Forex stands for “Foreign Exchange” and each of these words mean:
Foreign: belonging to, or characteristic of some place or country other than the one under consideration.
Exchange: the act of giving or taking one thing in return for another.
Every currency that is not the one in our country is considered foreign, so when we exchange one currency for another we are trading in the Forex Market.
A very interesting thing is that even if we’ve never touched a Forex Trading Platform, it’s very likely that we’ve been part of the Forex Market for longer than we think.
Every time we traveled to a country were they used a different currency and we had to perform an exchange of that currency, we accomplished a forex trade.
Something very important to point out is that the Forex Market is not the same as a stock exchange, here’s why:
- A particular stock exchange is a centralised place because all trades are happening there.
- The Forex Market is decentralised as there are many trades happening all over the world in different places at different times, there’s not one location where all the action happens but it’s rather spread out globally.
Now, let’s get into detail on how all of this works.
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How does Forex Trading Work?
In order to understand how Forex trading works we need to differentiate something from the start:
It’s not the same thing to physically exchange currencies when you travel, or through your online bank than doing so in most of the online CFD brokers.
When you trade Forex in online CFD Brokers you’re speculating on the price of currencies and you’re never getting ahold of them, for this reason we recommend that you read our CFD trading guide first (if you’re not familiar with the subject) so we can be on the same page.
Assuming we’re synchronised with the CFDs subject, let’s dive into how forex trading works:
What happens is that two currencies get measured against each other, that’s why they’re called currency pairs. Here are a few examples:
- U.S Dollar vs. Japanese Yen
- Euro vs. U.S Dollar
- U.S Dollar vs. Great British Pound
So when you trade forex you’re doing so under the assumption that one currency will go up or down when measured against another one and all of this with the objective of profiting from the trade.
There are several factors that affect currency prices, but the most important thing to keep in mind as we progress through the guide is that a country’s currency reflects how the economy of that country is performing, so Forex prices are the result of the actions of buyers and sellers which in turn make decisions by judging the economy belonging to the currency they plan on trading.
Types of Currency Pairs
As we said before a currency pair is a combination of two different currencies measured against each other.
These currencies have different types: major, minor and exotic. Let’s look at the main differences:
Major Currency Pairs
Major currency pairs are the most traded ones and hence the most liquid (by liquid we mean that there is a lot of availability).
The main characteristic is that these major currency pairs always include the U.S Dollar, here are some examples:
Minor Currency Pairs
Minor currency pairs belong also to strong economies and are widely traded but they don’t include the U.S dollar.
Exotic Currency Pairs
Exotic currency pairs are those made from a combination of a strong currency against an emerging country’s currency.
One of the most important things to consider about exotic currency pairs is that usually they are not that liquid and are subject to a lot of volatility.
What is Base and Quote in Forex?
Base and quote are what we call the first and the second currency in any forex pair. The base currency is the main one in the forex pair and we will express its value using the quote. The quote is the secondary currency. When we show the currency pair’s price we’re actually doing it using the quote.
So combining it all, when we see a currency pair’s (or forex pair) price we’re looking at how much quote you need to buy the base.
Which are the Forex Market Hours?
The Forex market is open 24 hours a day all over the world due to the international nature of itself.
There are many different places where Forex is being traded world wide in several different timezones, this results in you being able to trade every week from 5 p.m. EST on Sunday until 4 p.m. EST on Friday.
Logic Behind the Forex Market
One of the most interesting things is that people tend to look at forex trading in a very abstract way like an isolated thing happening just in trading platforms and this couldn’t be more wrong.
There are many reasons for the Forex market to exist, its not there just for the sole purpose of speculating on trading platforms, there are many market players executing transactions that they need such as countries, businesses and many more.
Here are a few examples of the forex logic:
International Trade
Suppose that Toyota (Japanese car maker) made huge profits in the U.S market and at the end of the year they want to bring back those profits to Japan in order to reinvest them, here’s how it looks:
So Toyota will perform a huge Forex trade at the end of the year to exchange their U.S Dollars for Japanese Yens and this transaction will have an impact on the market’s prices as there are thousands of companies doing the same back and forth for whatever reason they have.
So now you know, understanding market players is one of the most important things in order to scout for Forex trading opportunities.
The Traveller
Every time you travel to a country with a different currency than yours, you become a part of the Forex Market.
For example, if tomorrow they announce that God will appear in Ukraine then probably all the world will book tickets or drive to be there and you’ll immediately see the currency’s price shoot up due to an exaggerated demand.
The Speculator
Speculators are just traders looking to make a profit without having any real interest or use for the currency itself, they just want to buy or sell and squeeze money out of that action.
A very fun thing to note is that the majority of Forex transactions are done with speculative purposes, this means that we’re all just trying to squeeze money with no real interest on what we trade.
Must know Forex Terminology
What is a PIP in Forex?
A PIP (point in percentage, price interest point) in forex is the smallest price measurement change in currency trading.
In most currencies the PIP is the 4th decimal position:
So, if the EUR/USD pair changed from 1.1234 to 1.235 we can say its price changed 1 PIP.
A PIP in the Japanese Yen
The Japanese Yen doesn’t have 4 decimal positions, so in this particular case the PIP is the 2nd decimal position:
So, if the USD/JPY changed from 110.23 to 110.24 we can say its price changed 1 PIP
Why use PIPs in Forex?
First of all we need to answer something: Why are there so many decimals in Forex currency pairs?
Well, there are so many units of any currency available that they needed to make them divisible enough to allow small changes in an extremely liquid and highly traded market.
Imagine if one day you woke up and your currency could only move in 0.1 increments and your salary loses 10% value, makes no sense right?
Also with regards to why using PIPs, which of these sentences sounds better and more comfortable for you:
- The EUR/USD changed zero point zero zero zero one.
- The EUR/USD changed 1 PIP.
That says it all, it's much more comfortable to use PIPs to discuss currency price changes than to use traditional ways to express numbers.
Leverage in Forex Explained
Leverage is a financial tool that amplifies you're buying power and maximises your profit and losses potential. We love to call it a double edged sword or trading on steroids.
There is a lot of confusion with this subject as its approached in many different ways depending on the assets you trade or even the broker.
Traditionally leverage is all about trading with money that is not yours which your broker borrows you at a premium interest rate per night (called the overnight fee).
So for example, if your forex trading account has 500$ and you’re leveraged 1:5 this means that you can actually trade forex with 2500$ as long as your 500$ answer for the price fluctuations of that total 2500$ investment.
There are many leverage multipliers, you can see anything from 1:2 all the way up to 1:3000 or god knows what else could be out there.
One very important thing to keep in mind is that ESMA (European securities and Market authority) passed a law on this subject and restrained the leverage given to most retail investors to a maximum of 1:30. This happened because most new forex traders were either going nuts trading or being deceived by malicious brokers into losing and leverage assisted greatly on that as it can amplify wildly in a good or bad way any trading activity.
One of the most important things you need to consider when trading Forex with leverage is that you’re most likely trading CFDs (contracts for difference) and not the real currency itself. That’s why brokers make leverage easily available as you’re just trading mirrors of the real market and not the real asset itself.
How to Calculate Margin in Forex?
Margin in Forex is the required amount of funds to open and to maintain open a trade. In order to calculate the margin in forex you need to take the total value of your investment and divide it by your leverage.
Investment Value / Leverage Factor = Margin
Remember, whenever you hear the word margin that means that there is leverage involved, otherwise, you wouldn’t need margin.
What does Spread Means in Forex?
Spread is the difference between the buy and sell prices. Here’s an example with the Japanese Yen:
- USD/JPY Sell Price: 106.22
- USD/JPY Buy Price: 106.26
The spread gets charged instantly when you open a trade as you’re always going long or short at a more expensive price.
The spread is one of the ways that brokers use to make money, charging that small differential every time you open a transaction can be very profitable in the long run.
What is the difference between Forex and Forex CFDs?
Forex itself is when you actually own currencies (could be in your bank, cash, etc). CFDs on forex are just speculative contracts between you and your broker, they don’t give you ownership rights over the currency in question, they just give you the right to profit or lose based on your trade.
What is Scalping in Forex?
Scalping is all about opening and closing trades in extremely short timeframes such as seconds, minutes.
Bear in mind that this type of strategy nowadays is being executed by hedge funds and investment banks with access to super computers and technology beyond our knowledge, so most retail traders attempting to scalp the forex markets end up bleeding money non stop.
The Forex (FX) Economic Calendar
What is the Economic Calendar?
In simple words the forex economic calendar is just a calendar displaying significant economical events that occur worldwide.
For example, a country’s interest rate decision (which affects its currency), a country’s crude oil inventories (which affects prices of oil), a country’s employment situation (like the NFP in the U.S which affects the U.S dollar).
It’s an extremely important tool as it points us in the right direction to understand when can something happen with the assets involved and how important the event could be.
How does the Forex Economic Calendar usually looks?
Everyone claims to have the best calendar, but in reality most of them are the same, there’s nothing groundbreaking about an economic calendar. Usually they look like this:
All you need to do is pay attention to the country in question of the event, the event value, previous value and the new value that comes out. Forecasts usually miss it horribly so never rely on them.
On the next event just stay looking at the chart of the asset involved in your event and watch it fluctuate live in front of you.
What is the NFP in Forex?
NFP stands for Non-Farm Payroll and it’s the most important employment report in the U.S.
It’s called Non-Farm Payroll because it excludes farming jobs due to being highly seasonal positions that could alter the real result of the employment situation.
This report has an extremely strong impact in the U.S Dollar prices so for Forex traders the NFP is one of the top moments of each month.
The whole point of the report is to show how many jobs where added to the payroll (or not) each month.
Stay alert for the next opportunity to watch it live and wait for the first Friday of each month, find the report’s release time and watch the EUR/USD live, you’ll be amazed!
What Moves Forex Prices?
Now that we have a good basic understanding on how all of this stuff works we need to talk about what moves the prices. Here are the top drivers:
Political decisions and major events
Most of the events on the economic calendar are the result of political decisions, such as changing the interest rate of a country’s central bank or adjusting minimum wages. This decisions can have a strong impact on a currency’s value.
There are also major events for example war between two countries, this could result in huge shifts in supply and demand for certain assets, currencies and all of these become trading opportunities.
Natural Supply and Demand
The Forex market and pretty much any market’s prices are determined by buyers and sellers, every time there is an increase on each side the prices move accordingly, it’s up to us as Traders to determine why these increase could be happening and what actions could we take.
Market Manipulation
No market regardless of how large it is can escape manipulation, even the forex market.
If a huge bank wants to push prices of currency up, they will find a way to do so, so we must stay alert for strange unexpected movements and weird patterns that make no sense, they can be the result of market manipulation.
Conclusion
Forex trading consists of exchanging currencies and measuring them against each other. It's the largest and most liquid market in the world, also, it's available nearly every day. Regardless if we knew it or not, we're all part of it as currency transactions are taking place every second behind the scenes.
Forex trading gives you a good insight on how a country's economy is performing, strong currencies are associated with healthy economies and weak currencies with underperforming ones.
To finish our guide we want to leave you with a little food for thought:
If the president of the U.S wakes up tomorrow and announces a huge tax on whatever he can think off, and this tax affects many companies profits and could potentially reduce them by half, here’s what could happen:
- Investors will wake up screaming in panic
- They will start selling their shares before they drop
- If suddenly Japan announced a super favourable measure they will buy Japanese Yen
- All the investors will start buying Japanese shares.
This is a crazy example but it serves to make a solid point, the markets are crazy and it’s all connected.
Even just a few words from the president can send a currency falling from the sky or skyrocketing as ultimately those words will become monetary policy, tax laws and traders and investors are just waiting on how to respond to them.
Good Luck!
Frequently Asked Questions
Best Forex Trading Platform
There is no such thing as a best forex trading platform. In reality what matters is the quality of the broker itself.
All platforms are almost the same, maybe some more good looking than others, but overall they perform the same function. Here’s what you should care about:
- Are you trading Real currencies or CFDs?
- If you trade CFDs, are you leveraged according to the right laws?
- Is the execution of the broker good?
- Is your broker regulated?
If you’re positive on those questions then you're off to a good start.
Though we acknowledge that some platforms can definitely give you an edge once you're a professional by making your trading experience more comfortable, what we're trying to say is that it doesn't matters that much to think of it as the reason that you'll be successful in trading. We know quite a lot of bad traders using pro trading platforms.
How do people approach Forex Trading?
There is a long life discussion about how to approach Forex trading, some people are cheering for fundamental analysis and others for technical analysis.
Fundamental Analysis is all about determining the intrinsic value of something regardless of the market price, in simple words it means figuring out if something is really worth its price or not.
Technical Analysis is all about using past price data to figure out from that behaviour what could happen on the future.
Is one of them better than the other? We believe not.
Every forex trader should use both to ensure he arrives at the most accurate decisions possible.
Why so many traders lose money?
70% to 90% of retail traders lose money and all because of:
- Lack of knowledge on the Assets they trade
- Lack of knowledge on risk management
- Lack of funds to actually afford the risk of trading
Have you noticed the common word? KNOWLEDGE! The main problem is that people try to trade forex without studying a lot first and that results in sure losses.
So don’t be in a hurry, never use money you can’t afford to lose and study as much as you can.
Can you really make money trading forex?
Yes you can, assuming you don’t fall victim to the lack of knowledge anything is possible.
The most important thing to learn when entering the trading arena is risk management, so we heavily recommend that you invest always as much as possible in educating yourself from reliable sources before trying to invest large amounts of money.