What is foreign exchange trading and how does it work?

In this guide you will learn everything you need to know about the forex market, the largest financial market in the world. And then we’ll talk about Forex trading, the most popular way to speculate on the movements of different currency pairs with the aim of making a profit.

What is Forex?

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

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

In the foreign exchange market, one currency is exchanged for another, such as euros (EUR) for dollars (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 starting our trip, we go to our bank and exchange our currency (e.g. Euro) for the currency of the country we will travel to (Dollar, Yen, Pound…).

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

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

Who participates in the forex market?

Given the sheer size of the forex market, you may wonder: who are the participants in the forex market?

We could group them into three main groups:

Banks: either central banks, commercial banks or investment banks.

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

Individuals or small businesses: anyone, among others, for trading or to make purchases from an online store in another country. This group also includes small businesses, brokers, etc.

What is foreign exchange trading?

Foreign exchange trading consists of speculating on the price fluctuations of currency pairs in order to make an economic profit from the difference between the buying and selling rates.

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

Currencies for Forex Trading

A currency is a foreign currency, that is, an official currency other than that of 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 with the dollar.

This is called currency pairs or currency pair crosses.

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

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

Major currency pairs are the most frequently 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 against the Japanese yen

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

EUR/JPY: Euro against Yen

AUD/NZD: Australian dollar against New Zealand dollar

EUR/GBP: Euro against Pound Sterling

EUR/CHF: Euro against Swiss Franc

Finally, there are the exotic pairs, which are crosses between a major currency and another currency of 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 believe that the base currency will rise in value and therefore be more expensive to sell.

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

In short trading, 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 currency pair USD/CAD (US dollar/Canadian dollar):

The short trade can be a little 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).

Basics of foreign exchange 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 quote currency.

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

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

Price: is the rate of the currency cross

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

EUR/USD 1.22

The number on 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 above example EUR/USD 1.22? It means that for 1 EURO we would get 1.22 DOLLARS.

Why does the forex market move?

Forex pairs move because of various factors that affect currencies. Among the most important are:

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

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

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

Opening hours of the foreign exchange market

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 evening at the close of the US market.

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

London

New York

Sydney

Tokyo

Basic forex trading terms

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

Forex broker

A broker is an intermediary company that allows us to trade in the forex 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 the SPREAD, which is the cost of the trade.

In simple terms, the spread in forex trading is the money a broker charges to execute your trades.

What is a PIP?

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

Lots

A lot 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.

Leverage

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

Margin

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

Why do people trade forex?

Let’s go over some of the reasons why people trade forex, 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 exit a position in most currencies. Therefore, it is known as a very liquid market.

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

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

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Disadvantage:

One must be very attentive to the different news and events, as they can 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 like the stock market.

How to trade foreign exchange

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

Spot Forex

CFDs

Futures contracts

Options

ETFs and ETNs

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

To put it simply, to trade in the forex market you need to do the following:

open an account with a broker.

An account with a broker is always required to trade the various currency pairs and place buy and sell orders.

  1. analyze the market for opportunities

When analyzing a currency pair to know when to buy or sell, the two most commonly used 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.

Fundamental 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.

  1. 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 like Metatrader or Tradingview.

And for monitoring the main news affecting currencies, we can access websites like Forex Factory.

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 to open it.

Strategies often include elements of various analytical methods and a variety of tools that attempt 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 when trading, among many other things.

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

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

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