What is Forex Trading and How Does it Work

Ryan Myers

What is Forex?

The Forex, or foreign exchange market, is the online marketplace for currency trades. The market empowers investors and traders to potentially see profits from currency fluctuations related to the global economy.

Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.

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Who Invests in Forex?

The forex playing field is dominated by big banks, corporations, and investment funds. There is, however, a growing number of retail investors and day traders looking to cash in on the market. Commercial and investment banks account for a very large portion of total currency volume trades for both clients and their own speculation.

Central banks who control their respected country’s price stability are huge players in the forex market because open market operations (purchases or sales of government securities) and interest rate policies directly influence currency rates. After the large banks, investment managers and hedge funds make up the second largest players in the market as they trade currencies for large accounts such as pension funds and endowments.

On the whole, the volume of trades made by retail investors or your average YouTube forex speculator is very low compared to other traders.

Centralized and Decentralized Financial Marketplaces

The foreign exchange (forex) market is a decentralized financial marketplace. In a decentralized market, technology allows investors of securities to deal with each other directly instead of meeting at a centralized exchange. A common example of a decentralized market is real estate, where buyers deal directly with sellers.

By contrast, a centralized market refers to a specialized financial market that is structured in a way where all orders are routed through a central exchange that has no other competition for those financial instruments. The New York Stock Exchange is a centralized market because all orders route through the exchange.

Forex is actually the largest financial market in the world. This means that on an average day, the forex market has a trading volume of about $5 trillion while equities (the stock market) only trades about $84 billion. Volume of trade is the total quantity of shares or contracts traded for a specified security.

Foreign Exchange Fluctuation Rates Explained

If you have ever traveled outside your country of origin, you have likely exchanged money for a different type of currency. For instance, if you live in the United States and take a trip to Canada, then you will likely exchange some US dollars for Canadian dollars. The rate of exchange is what you will get back when you exchange currencies.

Right now, the exchange rate for American currency into Canadian currency is 1.35 (USD/CAD=1.35). In other words, for every American dollar that you exchange, you will receive 1.35 Canadian dollars.

These exchange rates fluctuate based on the supply and demand in the foreign exchange market. A high demand for a currency or a shortage in its supply will cause an increase in price.

The way a trader makes money in the forex market and what trades are based on is due to the fluctuation of exchange rates.

Let’s give an example of how forex trading works. Say that you live in the United State and decide to travel to Canada. On the day you arrive, you trade $500 American dollars at the rate of USD/CAD=1.35 (1.35 CAD for every 1 USD). This exchange gives you 677.08 CAD. On your trip, you manage not to spend any money, so you still have all 677.08 CAD when you come home.

During your time in Canada, the exchange rate changed from 1.35 to 1.25, so you actually receive $541.66 USD when you exchange your currency back into USD. You have now gained $41.66 just from holding your money in CAD while the exchange rate changed.

How Does Forex Trading Work?

Fortunately, you do not need to travel the world to benefit from fluctuating exchange rates. In fact, forex trading typically works by trading currency through online exchange offices called brokers. Online brokers allow traders to exchange currencies throughout the day and take advantage of constantly fluctuating exchange rates from their own computers.

The forex market is open continuously from 4:00pm CT Sunday to 4:00pm CT Friday. A trading day starts at 4:00pm and ends at 4:00pm CT the next day. The market needs to be open around the clock because of the global nature of the economy.

In my personal opinion as an author, day trading forex is too similar to gambling to bring steady profits to those with little experience with these types of markets. In fact, forex trading is often compared to gambling. This is especially true when the traders in question are new to the investing world with little to no education or experience. Ordinary folks who invest strictly in historical price patterns put themselves at risk of losing everything. It’s important to remember that the forex market was originally intended to be a hedging tool for big companies and investors; not an income source for day traders.

For anyone looking for a basic understanding of the key elements of trading forex, I’ve tried to condense my research and present it in the simplest way possible.

Currency Pairs

Forex trading works by exchanging currency pairs, not just a single product – you are actually trading two currencies against each other. A currency pair is nothing more than the exchange rate between two currencies. Even though there are two currencies, the pair itself acts as a single entity, like a stock or commodity.

Just like when trading stock, investors profit when they buy a currency pair and its price increases. Investors can also profit when they sell or short a currency pair and the price decreases.

The first currency listed in a forex pair is called the base currency and the second is called the quote currency. The price of a currency pair is how much one unit of the base currency is worth in the quote currency.

Let’s look at an example. Suppose an investor believes that Europe’s economy is going to grow faster than the United States. As a result, he/she thinks that the Euro will strengthen against the US dollar. She can buy the EUR/USD pair to speculate on her assumption. In this currency pair, EUR is the base currency that you are buying when you trade the pair and USD is the quote currency that you are selling when you trade the pair. If the euro rises against the dollar, then a single euro will be worth more dollars and the pair’s price will increase.

Lots and Pips

Currency pairs typically trade in specific quantities called lots. A lot is the amount of the currency pair that you are buying or selling. The most common lot sizes are standard, mini, and micro. Standard lots represent 100,000 units, mini lots represent 10,000 units and micro-lots represent 1,000 units. It may be crazy to think that in buying one mini lot you control 10,000 units of currency; however, exchange rates change so slightly in the form of pips that you really are not taking on a serious amount of risk.

A pip is the measure of change in an exchange rate of a currency pair. It is a standardized unit and is the smallest amount by which a currency pair can change. It is usually $0.0001 for US dollar-related currency pairs. For yen-based currency pairs, the method is different because the pip corresponds to the second decimal digit. This standardized size helps protect investors from huge losses.

How do we calculate the value of a pip in terms of its monetary worth?

The amount of the base currency (in lots) times the amount of pips equals the amount in the quote currency. For example, if an investor purchases a standard lot (100,000 units) of EUR/USD and the exchange rate increases by 1 pip, you would multiply 100,000 by 0.0001 for a profit of $10.

Still with me? I’ll try to bring this concept all together with a trade example.

Say a trader buys 1.5 standard lots of GPB/USD at 1.2530. The price then rises to 1.2542 and the trader closes his/her position. The trader has made a profit of 0.0012 pips. The formula for understanding the profit in dollars would be £150,00 times 0.0012 pips to yield $180 in profit.

Trading Forex on Margin: How it Works

A margin account involves borrowing to increase the size of a position. Traders may use this method to improve their returns. To begin forex trading, traders must first open an account with an online forex broker. Once the account is open, the trader then establishes a funded margin account. In a margin account, the broker uses the funds similar to a security deposit.

When you trade on margin, you only need to put up a percentage of the total investment to enter into a position. This amount is known as the margin requirement. Trading forex on margin allows traders to increase their position size by opening leveraged trading positions.

When you trade other securities like stocks, trading on margin means you are borrowing money from your broker. When trading forex, however, trades can only be covered using funds in the investor’s forex account.

Forex margin requirements vary depending on the currency pair and the size of the trade. Margin requirements can be as small as 2% of a trade or as large as 20%. The margin requirement for most currency pairs is 3%-5%.

Trading on Margin: An Example

To understand how margin is calculated, let me give you an example using the euro versus the US dollar pair.

Say the pair was trading at EUR/USD=1.1 and an investor wants to buy a standard lot (100,000 units). The cost of the trade would total $110,000, which is an enormous amount of capital for your beginning forex day trader. Because of margin requirements, however, that trader doesn’t actually need to pay the full amount. For instance, let’s say the margin requirement was 3%. The amount that the investor needs in their forex account to place this trade comes to 3% of $110,000, which is $3,300.

If the investor’s position worsens to the point where his/her net losses approach the already paid margin requirement, the broker may initiate a margin call. If this happens, the investor will either be forced to add funds to the margin account or close the position entirely. Margin calls protect the broker from inheriting the investor’s losses in the event that more money is lost than the initial margin requirement. Looking back to the example in the previous paragraph, if the investor’s losses were approaching $3,300, their broker would be likely to initiate a margin call.

Forex Trading: Technical Analysis or Gambling?

Forex trading by mature, retail investors are considered by many to be nothing more than gambling. One look at the erratic and seemingly random exchange rate fluctuation charts supports this theory. However, many large financial institutions and some individual traders are able to consistently bring in a profit.

Investors base currency trades on both fundamental and technical analysis. A trader using fundamental analysis would examine things such as interest rate parities, inflation rates, or global corporate earnings.

A more common strategy used by day traders is the technical analysis of price patterns and graph trends. Hardcore technical analysts do not even concern themselves with macroeconomic news. These technical strategies seem to work for some investors because traders all over the world watch the same charts and use similar strategies that then create self-fulfilling prophecies.

Generally, the forex brokers report to regulators that about 60-70% of their retail clients lose money while trading. Forex retail trading is not a secret online marketplace full of easy profits. Investors are gambling with their money to an extent and losses can force you to find a new hobby – especially when heavily leveraging your positions.

Author’s Note on How Forex Trading Works

My purpose in writing this article is to present readers with an understanding of how the various elements of forex trading work as a whole. Foreign exchange trading, at least for speculative purposes, is a zero-sum game. This means that every one person’s gain is another’s loss. Beating the pros, more specifically the pros’ computerized trading bots, is extremely difficult. Forex for speculation, especially for an individual retail investor, is very unlikely to be profitable over the long term.

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Ryan Myers