Learn all about what forex trading is and how foreign exchange works

With around 10 million people trading forex worldwide, the foreign exchange market is the biggest and most liquid financial market, attracting a great deal of interest for quite a few reasons. The main reason is the size of the foreign exchange market. Its trading volume is massive. In fact, according to the Triennial Central Bank Survey of FX and OTC (over the counter) in 2019, there was actually a daily volume of $6.6 trillion.

Forex exchange, also known as forex or FX, refers to the global marketplace where one currency is being exchanged for another. For instance, you can exchange the euro (EUR) for the U.S dollar (USD), just like you do when travelling in a foreign country. Specifically, if you live in a European country and want to buy something from the USA, then you will need to pay in U.S dollars, meaning that you will be exchanging the equivalent value of euros into U.S dollars. Likewise, if you are visiting a landmark, where euros for example, are not locally accepted as a currency, you will need to exchange euros for the local currency at the current exchange rate.

In online trading, these foreign exchange transactions occur in the so-called foreign exchange market. Interestingly, there is no centralised location or exchange for the forex market as currency trading is conducted over the counter, as an electronic marketplace consisting of banks, forex brokers, institutions and individual traders.

Forex traders can trade in the forex market 24 hours a day, for 5 and a half days per week. The trading of currencies occurs around the globe in the biggest financial centres of Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo and Zurich. Therefore, there are various time zones meaning that when trading in the U.S. ends, it begins in Tokyo and Hong Kong. As a result, the forex market is extremely liquid and overly active with price quotes changing all the time.

Besides forex, some investors prefer trading shares, meaning that they go long (buy) or short (sell) on the share price of companies listed on the stock exchange aiming to generate profits. Other investors are more into trading commodities, trading raw products like oil, coffee and more.

What is forex trading and how does it work?

As already mentioned, trading forex is as simple as exchanging one currency for another. The exchange rate, or value, of most currencies is the exchange price between the two currencies and is determined by the forex market. At the same time, it is also what drives the market.

Although there are officially 180 different kinds of currencies worldwide, the majority of forex exchange and transactions internationally are made in USD, GBP (Great Britain Pound), JPY (Japanese Yen) and EUR. There are other well-known currencies such as the AUD (Australian dollar), CHF (Swiss franc), CAD (Canadian dollar), and NZD (New Zealand dollar). Spot transactions, forwards, swaps and option contracts where the target instrument is a currency, are some ways to trade currencies.

Online forex trading trading is a network of forex traders buying, selling and transferring currency between each other at a predetermined price. In other words, trading forex is how different individuals, forex brokers, and central banks exchange one currency for another. Most of the time, this is done for the practical reason of generating online revenue. Since there is a vast number of currencies converted daily, the price movement of currencies become extremely volatile. Volatility in forex is the reason why so many traders are attracted to this market. However, possibilities for higher returns also entail higher risks.

Trading currencies and the foreign exchange market

Besides converting one currency into another, the foreign exchange also involves trading currencies on the foreign exchange market. This means that forex traders may predict an easing monetary policy, meaning that a central bank will lower rates and a currency may become stronger than the other and vice versa.

Currencies are traded in pairs. For example, USD/EUR, EUR/USD, or USD/GBP represent the U.S dollar versus the euro and so on. These pairs are associated with a price, of 1.2548. Taking the USD/EUR as an example, if 1.2548 was associated with the USD/EUR currency pair, it means that it costs 1.2548 EUR to buy one USD. If this price increases, it means that the value of USD increases too (and the value of EUR decreases) as it costs more in euros to buy one U.S dollar. 

There are also some other important concepts to take into account in online trading. Forex traders trade currencies in lots. There are micro, mini, and standard lots. The first one is worth 1,000 of the underlying currency, the second one 10,000, and the standard 100,000. Trading in an OTC market, like the forex market, means that you can place trades in predetermined currency blocks and that you can trade unlimited number of blocks. You can trade 6 micro lots (6,000), 2 mini lots (20,0000) or 15 standard lots (1,500,000).

What is a forex broker?

Forex brokers are a vital part of the forex market. To start with, a forex broker also known as a retail forex broker or a currency trading broker, is a financial service company that gives traders access to a platform to buy or sell foreign exchange currencies. As already mentioned above, the market is open 24 hours a day/5 days a week and operates globally. An online forex broker serves retail currency traders, who speculate on the currencies’ movement through a trading platform as well as big financial services firms, who are the intermediary between investment banks and other clients. Compared to the volume of the forex market in total, individual forex brokers can only manage a small percentage of traders.

Since the majority of foreign exchange transactions occurs among the currency pairs of the nations that make up the G10, including the USD, EUR, GBP, JPY, AUD, NZD, CAD and CHF, brokerages allow traders to trade in other emerging currencies. Additionally, by using a forex broker, traders can easily place a trade and buy a currency pair while selling it upon closing the trade. Put simply, if traders want to exchange pounds for dollars, they will need to buy the GBP/USD currency pair, meaning that they will buy pounds using U.S dollars. On the contrary, when traders close the trade, they will sell this pair, meaning that they will buy dollars with pounds. Traders’ profit will be determined by the exchange rate, which if higher when the trade closes, then traders make a profit whereas if it is not, they take a loss.

How do forex brokers work?

To work with a broker, traders need to open an account and deposit funds, which is quite easy nowadays. What’s good about trading with a forex broker is that traders get to trade with leverage in order to trade bigger amounts than what they had deposited. The leverage ratio is determined by the trader’s country. However, bigger leverage entails a bigger risk of losing money.

Now, as far as how brokerages are compensated, there are actually 2 ways. Firstly, they generate revenue through the bid-ask spread of a currency pair. This is also known as the buy-sell spread and it is the difference between the amount someone wants to sell a currency for compared to how much they are willing to buy for it. For instance, if the USD/GBP currency pair is quoted as 1.30010 buy and 1.30022 sell, the spread (difference) between the two prices is .00012, or 1.2 pips. When traders register with a broker and open a position at the sell price while later closing it at the buy price, then the forex broker’s compensation will be the spread amount – that is the difference between the two prices.

The second way is through additional fees. Some brokerages charge a trading fee per transaction while some others charge a monthly fee which traders can access specific software or trading products/platforms. Nevertheless, most forex brokers nowadays work with spreads and offer low or no fees at all.

Why trade forex?

So, why forex? And why is it so attractive to both experienced and new traders? First of all, the market’s high liquidity means that it is quite easy to buy and sell for a low cost. Moreover, forex brokerages usually provide educational support. For example, they provide videos, manuals and general explanations of what their platform’s features are all about. Also, they give traders access to educational articles or training regarding how to develop a trading strategy or how to boost their trading skills.

Additionally, flexible trading hours and a wealth of trading products provided to traders, suggest that trading forex offers unique opportunities.

Furthermore, traders won’t find the same fees or commissions that they would find on other markets because trading doesn’t occur on a traditional exchange. There is also no limit as to when to trade or not because of the flexible hours that the market offers. Finally, traders can get in and out of a trade anytime the markets are open.

Last but not least, due to the development of technology, traders are able to engage in the market in real-time through their desktop or mobile, practically anywhere with an Internet connection.

Is forex trading good for beginners?

Just like trading shares, or trading commodities, forex trading may seem like a scary and complex endeavour, but it’s actually relatively easy for beginning traders. In fact, there are actually numerous reasons why newbies start trading forex. Especially when it comes to exchanging one currency for another. Irrespective of buying and selling high or low, the mechanism behind profiting from online trading is rather straightforward.

In the past, only major market parties were involved in forex. Nowadays, however, the market is accessible to pretty much everyone and offers various resources and materials to facilitate new traders in their trading journey. Being a fast-paced market, the forex market offers great reward potential and losses respectively, even for beginner traders and has its own unique features, conditions, behaviour and risks that new traders should know prior to getting involved.

A tip for beginners who are just starting out would be to open a demo account and practise with a small amount of funds and then increase the amount, until they feel confident enough to enter with real funds.

Is forex a good investment?

As it becomes more and more popular, forex trading is now the most highly traded market. However, whether you’ve traded before or you are new to online trading, you may be wondering whether forex is the right market for you. Below are some reasons why you may want to invest in forex.

In a nutshell:

  • Technically anyone is able to trade, irrespective of their trading experience and background.
  • Accessible to everyone with only a small deposit of funds.
  • The market is open 24/5, so traders can trade anytime, anywhere.
  • Traders have control over risk exposure as they determine their stop-loss and exit orders.

Investing in Forex can help you generate a significant amount of funds but there are always risks involved. The trader’s level of experience and skills, their ability to put strategies into effect the right way, the amount of time they devote to learn how to trade online, how much they practise, study and how dedicated they are to conduct a market analysis will all play an important role in how successful their trading experience will be.

This information is not considered as investment advice or an investment recommendation, but instead a marketing communication. FXCess is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.