How Forex Trading Works

Foreign exchange trading, commonly known as forex trading or FX trading, involves establishing positions which involve the relative value of one currency over another.

There are many reasons why people and institutions establish foreign exchange positions, with most trades relating to what we could call a fundamental need for processing foreign exchange transactions.

Most forex trading involves banks converting one currency to another for instance, and as you might imagine, this involves huge sums of money, with some single transactions running into the hundreds of millions of dollars.

Even central banks get in on this action when they are looking to influence the relative value of their national currency. In cases of fundamental trading, the reasons behind the trades are not just for speculation purposes, but to satisfy some other need for currency exchange.

The speculative end of forex trading is representing a bigger and bigger part of the forex market though, and in this case the idea is to look to make money by speculating on price movements in exchange rates between currencies.

A lot of this speculation is conducted by institutional investors such as big hedge funds and investment management firms, but a lot of it now comes from the public as well, the so-called retail trade. The growth of the retail forex market in fact is what has driven a lot of the growth that we have seen in the forex market in past years, and a lot of this is due to the internet, putting professional grade tools and trading platforms in the hands of everyone.

The forex market has a huge amount of liquidity, meaning that it is very actively traded, with trillions of dollars changing hands in the forex market worldwide every trading day. Forex trades do not occur on any given exchange, they are instead executed on that is called the over the counter market, computers trading directly with other computers.

Since the forex market extends across several borders, the market itself regulates it, and this is as close to a market of perfect competition as you see in capital markets, virtually free of the influence and interference of regulators and their desire to constrain it to degrees.

Due to it being centered in several financial centers around the world in different time zones, forex trading occurs and is available 24 hours a day, 5 days a week, and this increased access particularly appeals to traders who may be doing it on the side and may work during normal market hours in their country.

Forex Trading Basics

Since forex trades involve trading exchange rates, they always involve trading the relationship of two currencies to one another, called a currency pair. Each currency pair has a three letter designation, for instance USD for U.S. dollars, EUR for the Euro, GDP for British pounds, CAD for Canadian dollars, JPY for Japanese yen, CHF for Swiss francs, AUD for Australian dollars, and so on.

Currency pairs are expressed as a combination of two currencies, for instance EUR/USD, where in this case the EUR is called the base currency and the USD is the quote currency. Currency pairs are usually expressed in a common format, for instance you wouldn’t see this displayed as USD/EUR in most trading platforms, as it is preferable to have currency pairs expressed in a common format with a common quoted price, which simplifies and facilitates trading.

In our example, you might see a quote of EUR/USD expressed as 1.1754 or 1.17542, which means that 1 EUR, the base currency, will buy the quoted amount of the quote currency, USD. Quotes used to be expressed to 4 decimal points, called points or pips, although now we see a lot more 5 decimal place quotes, which has the benefit of more accuracy.

Like all capital markets, prices are expressed in both the bid and the ask. The bid is the price that the market is willing to buy the currency pair from you at, and the ask is the price that you may buy it at.

The difference between the buy and the ask is called the spread, which is expressed in terms of pips. The spread does differ with different currency pairs and the smallest spreads can usually be found trading the highest volume currency pairs, called the majors.

The majors involve the most actively traded pairs, starting with EUR/USD, the most active of them. Cross pairs involve currency pairs that aren’t traded as frequently, and some of these pairs are fairly actively traded, although you can expect to pay a little bigger spread.

Forex spreads are pretty tight though overall, with the higher volume pairs generally offering a spread between 1 and 2 pips, with other pairs offering a little higher spreads but not too much higher. The tighter the spread, the more suitable it is for shorter term trading, with larger spreads being more suited to intermediate to longer term plays.

Trading Currency Pairs

In order to profit from a trade, the price needs to move enough in your favor to cover the spread, and beyond that, the rest is your profit in the trade. If the trade moves against you, you will lose the amount of the price movement plus the spread.

To illustrate this, if you bought a currency pair and sold it immediately with no price movement occurring, and the spread was 2 pips, you would lose 2 pips on the trade. This is the case with all financial trading, there is always a spread to overcome to make money on a trade.

Unlike other trading though, there are no fees or commissions to be paid on forex trades, as the spread is all you have to worry about. This is another reason why so many traders find forex trading so appealing, as this allows you to implement whatever strategy you wish, trading as frequently as you want for instance, without having to overcome both the spread and fees or commissions, which can make frequent trading in particular more difficult.

The spread with forex is also much tighter than you see in other capital markets, around two hundredths of a percent on average, an extremely small amount indeed.

Currency trading is far less volatile than you see in other markets, so having very tight spreads is required to make the trades desirable, as if you had to pay a lot bigger spreads then the spread may eat too much of your profits and even make speculative forex trading unsuitable for all but the long term.

Another big advantage of forex trading is that traders can go either long or short a currency by either buying or selling it, with no restrictions. The only difference between buying and selling a currency pair is which currency you’re going long with, and all trades go long one of the currencies and short the other in fact.

So if you buy EUR/USD, you are going long EUR, and the base currency is always the one which is designated by the buy/sell decision. If you expect the EUR to increase in value relative to USD, you would buy this pair, and if you felt that the USD would increase in value relative to EUR, you would sell the pair.

Exiting your position would always involve placing an order for the opposite side of the trade, for instance if you bought this pair you would sell the same amount to close out the position. The difference in the price between what you paid for the trade and what you received when sold, or what you sold it for and what you paid for it to close it if you are selling, is the net result of the trade.

The amounts that are bought and sold with forex trades are expressed in lots, with a standard lot being 100,000 units, a mini lot being 10,000 units, and a micro lot controlling 1,000 units. A trade consists of whatever amount of lots/mini lots/micro lots you wish to buy or sell.

Forex Is All About Leverage

If not for leverage, forex trading would be very dull indeed, and return on investment would certainly be nothing to get excited about. The much higher leverage available with forex is what makes forex trading viable to speculators actually. If not, you would have to put up a lot of money to make very little, and your rate of return even if you did very well would be very small.

Forex trades are placed through a broker, and depending on the broker and the currency pair you are trading, margin requirements will differ. Margin requirements can range from 20 times what you put up to as high as 500 times your investment.

More is not necessarily better when it comes to margin requirements though, as the more a trade is leveraged, the more risk that is involved. With forex, you don’t want all of your money in play at the same time anyway, unless you really are looking to take on a lot of risk, so you can control the amount of risk you take on simply by committing a higher percentage of your balance to trades if that’s what you’re after.

What you do want though is the ability to take on the maximum amount of risk you desire, and you want the amount of leverage involved to accommodate that, but even the more conservative margin requirements out there do that plenty well.

This is because risk is a measure of your exposure at any given time, so for instance having all of your funds committed to a trade with a leverage of 50 to 1 is the same as having half of it exposed at a leverage of 100:1. So while some forex traders, newer ones in particular, can get more excited by the ability to get higher leverage, this only may matter if one is going to trade with little regard to risk, which is usually a bad idea, especially if you’re not very experienced and skilled at forex trading.

Forex trading can let you decide how aggressive you can be and if you really want to be super aggressive, you can be, although it’s a good idea to trade on paper first, to at least get a good idea of what you’re getting yourself into and what you may expect with various trading strategies.

Forex trading is certainly an exciting and potentially profitable form of trading, provided you know or learn enough about what you are doing.