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What is Forex Trading and How Does It Work?

In its most basic sense, the forex market has been in existence in various forms since money was created and exchanged. Throughout history, humans have always exchanged commodities, coins, and paper money to buy and sell goods, and to build a financial system. 

But the modern forex market as we know it today is quite a new market, particularly the online forex market. Over the last three decades, and especially since the internet has emerged – forex trading is also a global network for currency trading where banks, hedge funds, central banks, governments, corporations, and retail investors all exchange forex currency pairs at any given moment. 

So, in this article, we’ll help you understand the basics of online foreign exchange trading. We’ll explain what forex trading is, how it works, and how you can start trading FX currency pairs. 

What is Forex Trading?

The Forex market, also known as the Foreign Exchange market, involves the buying and selling of FX currency pairs for the purpose of exchanging goods and services as well as for speculation. In essence., Forex trading can be done for various purposes including exchanging foreign currencies to a local currency, buying goods and services in other countries, investing in other regions in the world, etc.  

But the vast majority of online forex trading is made for speculative purposes and the goal of making profits. Simply put, it is a form of speculative trading in which traders exchange one currency for another in order to potentially make revenues. As a matter of fact, it is estimated that nearly 90% of the volume in the currency market is executed by speculators.

Fun Fact

The forex market is the largest and most liquid market in the world with an estimated turnover of $6.6 trillion per day. In terms of market volume, it is 27 times bigger than global stock markets.

How Does Forex Trading Work?

Unlike shares and futures markets, FX currency trading does not take place on any regulated exchange. Instead, forex exchange trading takes place between banks in what is called ‘over the counter’ (OTC) market or interbank market. This global network of banks creates a 24 hours 5 days a week market with no central location and no centralized exchange. 

There are three types of FX currency pairs – majors, minors, and exotic. Major currency pairs account for around 80% of the total volume in the forex market and include the EUR/USD, GBP/USD, USD/JPY, USD/CAD, USD/CHF, AUD/USD, and NZD/USD. Minor currency pairs are a combination of any currency pairs from the major currencies that do not include the US dollar (EUR/GBP, GBP/JPY, AUD/GBP, etc). And, exotic currency pairs are combinations of a major currency with a currency of an emerging country or a currency of a less developed or strong economy. For example, EUR/TRY, USD/SEK, GBP/HKD, etc. Find out more information about some of the best exotic currency pairs in 2022

As for the currencies structure – FX currencies are always traded in pairs, meaning you buy one currency and sell another. The pair is made up of a base currency, which is the first currency, and the quoted currency, which is the second currency. For example, if we take the GBP/USD – the base currency is the British pound while the quoted currency is the US dollar.

The smallest price movement in a currency pair is known as a pip, short for “percentage in point”.

Let’s say the EUR/USD moves from 1.1600 to 1.1601, it basically means the currency price changed by 1 pip.  

Each currency pair has a spread, which is simply the difference between the buying and selling prices, or bid and ask. The spread differs between forex brokers and is based on the type of market execution the forex broker offers (ECN/STP, market maker, etc). 

What is Leverage in Forex Trading?

One of the main attractions of online forex trading is the high leverage provided by retail forex brokers. For those unaware, leveraged trading (also known as margin trading), is a trading mechanism in which a trader borrows funds from the brokerage firm in order to be able to trade with a larger amount of capital than initially deposited. 

For example, online forex brokers offer forex trading with a leverage ratio of 50:1 to 1000:1 to allow traders to increase the size of their positions. Here, at SwitchMarkets, we offer a leverage ratio of up to 500:1 on major and minor currency pairs, which requires a trader to use only 0.2% of the account balance to be able to open a position. 

In order to better understand how leverage works in forex trading, below you can find a comparison table for each level of the leverage ratio and margin requirement.

The Risk of Leverage in Forex Trading

Even though leverage is a huge benefit in forex trading, it is important to note that the higher the leverage you use, the higher the risk. When you are using a high leverage ratio, it essentially means you increase the chances of making high profits but at the same time, you increase the risk involved in trading the forex markets. In short, leverage is a double-edged sword. 

For example, a leverage ratio of 100:1 requires a margin of only 1%. So, with a position size of $1,000, you would be able to control $100,000. This means that a value of one pip is equal to $10 and if the market goes against you by 100 pips, then you’ll automatically exit the trade (unless you deposit more funds). So, the best solution is to use a leverage ratio that you can deal with and feel comfortable when trading. In addition, in order to know your exit level and where to set your stop-loss, you can use tools like Forex Profit Calculator and Lot Size Calculator

What Determines the Value of FX Currency Pairs?

Currencies are traded in pairs, which means the value of a currency pair is determined by the strength or weakness of one country versus the other. As such, you need to evaluate the economic performance of one versus the other, and according to this data, take a decision to buy or sell a certain currency versus the other.

With that in mind, here are the main factors that affect the value of FX currency pairs:

  • Inflation and interest rates – Clearly, the number one factor that has a direct impact on the value of currencies is interest rates maintained by the country’s central bank. Simply put, when there’s an interest rate differential (IRD) between two currencies in a pair, investors will prefer to invest in the currency with higher interest rates and sell the one with the lower interest rate – a trading strategy known as carry trade
  • Economic Performance – A country’s economic performance is an early indicator of an interest rate hike and thus, an increase in the value of its currency. Therefore, economic data such as GDP, CPI, exports and imports, etc – are all crucial and ultimately affect the value of the currency. 
  • Geopolitical Stability – Obviously, a political state of a country is a major factor for a country’s economic growth and can affect the value of its currency. So, situations like war conflict, Brexit, elections, political instability, protests, etc – have a direct impact on a currency.
  • Balance of Trade – Balance of trade, also known as net exports, is the difference between the value of a country’s exports and imports. The meaning of a positive trade balance is that a country’s total exports exceed imports and thus, the demand for its local currency rises.
  • Speculation – At last, the forex market is extremely speculative. It is ​​estimated that 90% of the total volume in the forex market is fueled by speculators, so very often the main reason for a movement of a certain currency pair is simply a market trend and the growing demand from investors to make profits.  

Fun Fact

It is estimated that nearly 90% of the volume in the forex market is done by speculators.

What are CFDs in Forex?

Forex trading can be done in various forms including through banks, dealers, and online brokers. Any individual, for example, can visit a money exchange store or contact the bank to buy a currency and sell the other. However, CFDs, which are a popular form of trading derivative products, provide the best way to get access to forex trading.  

So first, what are exactly CFDs? A Contract for Difference (CFD) is a financial derivative contract in which two parties agree to speculate on the price of an asset without having to exchange, and hold it. For example, when you buy the British pound and sell the US dollar at your local bank, you are essentially transferring currencies, and you make a ‘physical’ exchange. The bank is responsible for transferring GBP to your bank account and transferring your USD to another account. 

When trading CFDs, on the other hand, traders can easily speculate on the future price movements of an underlying asset without any hassle to exchange and hold the currencies and pay high commissions. Notably, almost all forex brokers in the industry offer users to trade currencies in the form of CFDs. Some of the pros and cons of Forex CFDs vs Forex include:

Pros

  • CFDs allow you to trade on both rising and falling markets
  • High leverage ratio
  • To ultimate way to speculate on FX currencies price movements
  • Unlike conventional forex market, CFDs can be traded 24/5
  • Low trading costs

Cons

  • High risk
  • CFD Forex brokers charge an overnight fee, meaning it is less suited for long term positions
  • You do actually own the currencies, meaning you cannot use the currency you bought in case you need it

Forex Trading for Beginners

Make no mistake, forex trading is tough. You can essentially lose your money in a second and even if your first trade is profitable, don’t get too excited about it. You need to form a long-term trading structure and understand how the forex market works. In my view, the best way is to invest money you can afford to lose and use this money in order to learn how the market works and how to find the strategy that works best for you

Much like lawyers, accountants, and every other profession, you need to set a period of time, sort of an internship of 3-6 months, and learn how the fundamentals of trading and what makes currencies move in a certain direction. A great approach to achieve true expertise in trading is the 10,000 rule, which says that it takes roughly 10,000 hours of practice to become an expert in a certain field. I mean, it worked for the Beatles and Bill Gates so…

Regardless, there are few steps you need to take before you start trading forex:

  • Understand the basic terms of forex and the jargon of financial markets
  • Take forex online courses and free forex trading webinars about the Forex market and trading
  • Learn as much as possible about risk management tools – Risk/Reward ratio, risk management EA, stop-loss, and trailing stop-loss orders. 
  • Open a demo account that enables you to trade currency pairs with virtual money
  • Find a reliable news source provider and economic calendar

The 5 Steps to Start Trading Forex

Assuming you have completed all the steps above and you want to start forex trading, here’s what you need to do:

  1. Open an online trading account with a reputable and regulated forex broker
  2. Fund your trading account. It is recommended that you start with a small initial investment
  3. Select 1-3 currency pairs you wish to trade on and focus on these currency pairs
  4. Start trading
  5. Use risk management tools – Set a stop loss and risk-reward ratio

Forex Trading – Pros and Cons

Forex trading comes with some notable pros and cons that you need to consider before getting started:

Pros

  • Liquidity – the Forex market is the most liquid market in the world, which means you’ll always be able to find a buyer or seller when you want to open and close positions. 
  • Accessibility – Opening a forex trading account is not as difficult as opening a stock, futures, or options trading account. There are lots of brokers that provide a great trading environment, including a demo practice account and a variety of trading tools. 
  • The ability to short sell assets – The good thing about forex trading in comparison to the stock and futures market is that you can easily short sell currencies and take advantage of trading in both directions. 
  • Leverage – Forex brokers provide an extremely high level of leverage of up to 1000:1. Consequently, if you can form a successful trading strategy, forex trading could potentially generate high profits. 
  • Trading hours – Unlike the stock market, the forex market is open 24 hours a day, 5 days a week.
  • Low initial investment requirement – Unlike other forms of investment, there’s no need to make a large investment to start trading forex. Some forex brokers enable users to start trading the markets with a very low initial deposit. 

Cons

  • The risk of using leverage – As we mentioned earlier, leverage in forex trading is a powerful tool but it also significantly increases the risk of losing money rapidly.
  • High volatility – The FX market is known as a volatile and unpredictable market when compared to other markets. 
  • Price determination – In the forex market, price determination is somehow complex as there are various factors that influence the exchange rate of a currency pair.  Additionally, local government intervention can be a major factor to determine the value of currencies and often cannot be predicted by traders.

FYI

Cable is a known term among forex traders used to describe the GBP/USD currency pair. The term was first used in the mid 19th century when the GBP and USD were the most traded currencies in the world and transactions between the two currencies were executed via a transatlantic Telegraph Cable. 

Conclusion

To sum up, there are many reasons why the forex market has gained such popularity over the last two decades. Understanding the dynamic in the forex market is interesting not only as a way to earn money, but also to open our eyes to the world and get a better understanding of how the economy and financial trade works. Additionally, over the last few years regulation has improved and scammy brokers are quickly removed by regulators. This makes the forex industry more competitive and clean from frauds. 

The bottom line – whether you are a beginner or an experienced trader, the forex market is a great way to get involved in trading. If you are ready to do that, visit our sign-up page and open an online trading account. 

FAQs

Is forex trading profitable?

Generally, trading is subjective as there are many ways to analyze and trade forex. In online forex trading, the vast majority of traders lose money, largely due to the high leverage and because they usually enter the market not prepared. That said, trading forex can definitely be profitable if you reach the point of understanding the dynamics in the market and you are able to form the right trading strategy. 

How to open a real trading account on MetaTrader4?

MetaTrader4 is certainly the most popular online trading platform among forex and CFD traders. To open a real trading account on MetaTrader4, you need to find a forex broker like SwitchMarkets that gives users access to this trading platform and then open an online trading account. If you are not familiar with the platform, it is advisable to start with a demo account to get a better grasp of the platform and add funds to your live account when you are ready to trade the live markets. 

Is forex trading good for beginners?

That depends on many factors. Even though trading forex is considered a risky form of trading, it is a great place for beginners to start trading, and for several reasons. First, it is accessible and there’s no need to risk a large amount of capital as you might have to do when investing in stocks and futures. Secondly, forex brokers provide a great trading experience including online trading platforms, tools, leverage, and investment recommendations by their analysts. Finally, the forex market is less complicated than other markets, especially for beginners. You need to follow the news, understand macroeconomics and the political impact on FX currency pairs, and find the best hours of the day to trade the markets. 

What is an online broker in Forex?

In simple terms, an online forex broker is a financial services company that gives traders access to the forex market via online trading platforms. 

Do you need a forex broker to trade currency pairs?

In essence, no, there’s no need for a forex broker to trade currency pairs. You can do that by exchanging currencies at a money exchange store or buy and sell foreign exchange currencies at your bank. However, this way, speculating the prices of forex pairs is extremely difficult and you need large amounts of money to make small profits. Forex brokers, on the other hand, provide leverage and online trading platforms where you can actually trade currency pairs as an additional or main source of income. 

What is copy trading in Forex?

As the name suggests, copy trading is a technology that enables users to automatically copy the forex trades of other traders. It is mainly used by beginners or those who do not have the time and knowledge to research the forex market. Instead, they simply use the skills of other traders, which are in return compensated to share their trading activity. 

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