What is Forex (FX) trading and how does it work?

What is Forex Trading?

Reading time: 30 minutes

Forex trading, also referred to as foreign exchange trading or FX trading, is a global market whereby foreign currencies are exchanged. Some of the most common trades include exchanging Euros for US dollars or US dollars for the Great British Pound, or US dollars for the Japanese Yen. It is the largest market in the world and depending on its direction it can affect everything from the clothes and food that you buy to the cocktail that you order during a vacation. A vast majority of individuals that participate in the forex market work in large institutions such as banks, managed investment schemes and multinational corporations.

Contents

Forex Trading and How Does it Work?

1. Introduction to the Forex Market

Out of all the global markets, the forex market is the largest. It is not found in a central exchange and trades worldwide across major financial centres, such as London, Hong Kong, New York and Tokyo. The FX market facilitates the act of exchanging one currency for another. It could occur during an international commercial transaction or simply during a trip overseas and in contrast to the stock market, the FX market has higher liquidity.

A simple way to understand it is through online shopping. When purchasing an overseas product online, often the seller needs to be paid in their foreign currency. Depending on the value of one currency compared to the other, the buyer will either need to pay less or more for the same product. This act of exchange in currency is known as foreign exchange trading, also referred to as forex trading or just FX trading. For some things like online shopping, the exchange in currency may seem insignificant. However, the buying and selling of currencies is a vital component of the financial markets.

Fluctuations in currency values expose businesses to risk. The forex market provides a way to hedge that risk by fixing a rate at which the transaction can be completed in the future (generally achieved through derivatives).

2. A Brief Background of Forex

The forex market concept is believed to be introduced centuries ago by the barter system and then evolved through major events such as the gold standard, the Bretton Woods Monetary Conference and now internet trading.

Initially individuals would trade in goods. That was difficult though because it was hard for people to come to an agreed value. Gold coins were eventually widely accepted but proved inconvenient due to its weight. So printed money was chosen to represent the value of gold. However, this was suspended due to the catastrophes of the World Wars; the need to print more money to fund the war and the need for currency stability to facilitate and encourage international trade to help countries redevelop.

Eventually, with the advances in technology and aggressive international competition, the forex market has developed far beyond the barter system and much more towards a digital age and floating method.

3. Different Types of Forex Markets

Overall, there are three different forex markets. The spot forex market, the futures forex market and the forward forex market.

The spot forex market, or spot FX, is the physical exchange of currencies that occurs within a short period or the moment the trade is settled. For instance, when someone goes to exchange a currency at the bank, that person conducts a currency exchange ‘on the spot’.

The futures forex market, or currency futures, is a legally binding contract whereby parties agree to exchange a particular quantity of currencies, at a predetermined price, at some point in the future. This is attractive for corporations that import a large quantity of goods and seek to avoid costs (exchange rate risks) by fixing a predetermined currency rate to ensure they purchase the goods at a fixed price. The key difference between the spot forex market and currency futures is that with currency futures the underlying currency has a settlement period at a specific settlement date, sometime in the future.

The spot market generally settles an exchange in two business days (T+2). Although this may appear to be incorrect, the spot market usually requires two business days to settle the deal from buyer to seller, and vice versa. Weekends and public holidays need to also be kept in consideration as they can cause further delays to a settlement. There are exceptions to this rule such as exchanging the US dollar against the Canadian Dollar which settles on the next business day.

The forward forex market is like the futures forex market but is not legally binding. The futures market is simply a standardised forward contract. The forward market is an example of an over the counter (OTC) market, which is an agreement to buy something at a predetermined date at a specific price in the future. Unlike the futures forex market, the forward forex market does not have a daily limit on price fluctuations. In contrast, the futures forex market specifies a maximum daily price range to minimise exposure to fluctuations. With forward contracts there is also the counterparty risk that needs to be contended with.

4. Forex Trading and How it Works

There are different ways for someone to trade on the forex market, but they all involve the synchronised buying of one currency while selling another. With the rise of online trading, forex traders can now benefit from currency price movements by using derivatives, for instance, via CFD trading.

The foreign exchange is always traded in currency pairs (also known as forex pairs). So, a trader might want to compare the Great British Pound against the Japanese Yen, illustrated as GBP/JPY. The first currency in this example, GBP, is known as the ‘base currency’. The second currency, JPY, is known as the ‘counter currency’ or ‘quote currency’.

When trading on the forex market, a trader speculates whether the base currency will rise or fall compared to the counter currency. So, if 1 GBP buys 135.07 JPY, a trader might speculate that the GBP will get stronger and eventually will be able to buy 135.15 JPY instead, as an example. This is referred to as ‘going long’ if a trader takes a position with the expectation of price advancing (‘going short’ refers to a sell position). The price or rate of the second currency (the quote) reflects the value of the first currency (base).

5. Forex Terms to Remember

The price of a currency in terms of another currency is provided through a ‘forex quote’. These quotes always come in currency pairs because it involves selling one currency to buy another and vice versa. So, a currency pair will generally quote two different prices, as shown below.

The bid price is the price at which traders can sell a currency, and the ask price is the price that traders can buy a currency at.

6. Pros and Cons of Forex Trading

Forex trading has become popular. But just like every other type of trading, it comes with its benefits and detriments.

A benefit of forex trading is that it is decentralised. This helps keep the cost of trading low as the order goes directly to the broker. Another benefit of forex trading is that it is easy to enter and exit trades in most major currencies (high liquidity). Also, traders can use leverage to control large positions with a small percentage of their own money and since the forex market is a macroeconomic endeavour, trading currencies largely does not require an understanding of the nuances of micro-economic factors.

However, currency rates are influenced by multiple factors, such as global politics, market attitudes (sentiment), technical levels, news reports and even social media. This makes the forex market very volatile because these influential factors are sometimes difficult to analyse to draw any reliable trade conclusions. Furthermore, the forex market allows for high leverage positions, which means that traders can buy into positions with less capital but face higher risk of currency price fluctuations in their accounts.

7. Lot, Leverage, Margin, Spread and Pip

Pips & Lots: The value of a currency pair and trade size are quoted in ‘pips’ and ‘lots’. A pip expresses the change in value between two currencies, usually the last decimal point of a price quote. For example, if the currency value of EUR/USD is 1.2345 and goes up by one pip, then the new value will be 1.2346. Most currency pairs go up to four decimal places—a pip is simply 1/100th of a percent. Lots refers to the size of a trade when an order is placed on a trading platform. A 'standard lot’ (100,000 units of the base currency) is common in the FX space, with 'fractional' lots represented in the form of either 'mini lots' (10,000 units of the base currency) and 'micro lots' (1,000 units of the base currency).

Spread: This refers to the difference between the buying and selling prices. Typically, the price to buy a currency (the Ask) will be higher than the price to sell a currency (the Bid). The higher the volume traded and the higher the liquidity of the currency, the tighter the spread.

Leverage & Margin: When someone is trading on the ‘margin’, they take a larger position by depositing a small sum of money as collateral. The rest of the sum needed is ‘borrowed’. ‘Leverage’ is the ratio between the funds borrowed and the deposited margin.

8. Differences Between Long and Short Positions

Taking a position in the forex market has three main characteristics.

  • The choice of currency pair

  • The direction of the trade (going short or going long)

  • The volume being traded

Taking a long position or a short position in the forex market simply means that a trader speculates that the currency will either appreciate (going long) or depreciate (going short) relative to another currency.

9. Currency Pairs and Groups Explained

Currency pairs are placed in groups based on the volume that they are traded in.

Major pairs are the most popular traded pairs in the market and include EUR/USD, GBP/USD, USD/JPY, USD/CHF, USD/CAD and AUD/USD.

Minor pairs are less frequently traded pairs which often feature major currency currencies against each other, excluding the US dollar: GBP/JPY, EUR/GBP and EUR/CHF.

Exotic pairs are when major currencies are placed against a small or emerging currency, such as USD/PLN and EUR/CZK.

10. Factors that Move the Forex Market

Various factors can influence a currency fluctuation, many of which investors need to be aware of. This makes it difficult to make an accurate prediction on each trade, but they all tie back into the supply and demand. Just like other assets, currencies have their value determined by the number of people buying the currency or how many people are exchanging their own currency.

Central banks manage a country’s currency: interest rates and money supply. Since they trade over $6 trillion in various currencies per day, the financial strategies they choose to follow will have an impact on the economy. For instance, when inflation is predicted to rise dangerously above a set target, central banks will usually increase their interest rates to limit consumer spending growth, reducing inflationary pressures. This usually boosts a currency when interest rates rise.

Extreme weather also affects the forex market. In early 2022, severe floods and dry weather impacted Brazil, a global commodity powerhouse in agricultural products and metals (Tatiana Freitas, 2022). This caused commodity prices to increase globally.

Riots and wars also hugely impact the forex market. When there is a rise in social unrest, governments come into disrepute. This can cause individuals and other nations to trust governments less and hence be discouraged from trading with them and even impose economic sanctions, all of which can devalue a nation’s currency.

11. Forex Trading Strategies

The ability to follow a strategy with informed decisions is what separates trading from guesswork. Forex trading provides an excellent chance for traders to diversify their portfolio and even build a career around it, but they should know how to time their trades with charts and how to avoid impulsive behaviour with common sense.

Some take a technical approach with charts, signals and indicators to try and identify trends in a currency’s exchange rate to reveal where it will go next. Others take a fundamental analysis approach whereby they take a macroeconomic view and base their findings on a bigger picture.

12. Fundamental Analysis

Fundamental analysis involves establishing a value or target price using various economic data such as inflation, Gross Domestic Product (GDP) and interest rates. It is an assessment of a country’s economic well-being and, by extension, its currency. Traders try to ascertain macroeconomics trends and speculate accordingly. After all, history does seem to repeat itself.

13. Technical Analysis

Technical analysis tries to forecast price movements via historical price action. It uses things like indicators and oscillators, chart patterns, moving averages, Relative Strength Index (RSI) and Bollinger Bands. Technical analysis is exploited for both short-term and long-term investments.

Based on a particular pattern, for example, a trader will determine certain entry and exit points. With this approach, a trader might not be so concerned about why the price is moving but instead be more focused on the actual pattern of the chart and its signals.

14. Charts Used in Forex Trading

There are multiple charts available to use for forex trading. One is not necessarily better than the other, so choosing which charting method to follow will generally depend on each person’s trading style and preference. The main charts used are a line chart, a bar chart or a candlestick chart. On all those charts the y-axis (the vertical line) shows the price and the x-axis (the horizontal line) shows the time periods. Technicians use these charts to analyse and speculate on the market using different timeframes. They can look at data within a particular day, week, month, quarter or year. Note that lower timeframes, such as the 5-minute charts, are also employed.

Line Chart

The line chart provides a simple way for traders to view changes in price over time. The example above is a line chart that shows the intraday closing price of EUR/USD from 16 Aug 2022 to 17 Aug 2022.

Bar chart

A ‘bar’ in a bar chart is a vertical line as shown above that shows the open (where the bar began its life), high (highest traded point in the period), low (lowest point in the traded period of the bar) and close price (the value at which the bar closed as per the traded period).

The distance between the high and the low and the size of the bar tells a story to traders. A small bar with a small distance between the high and low illustrates a lack of interest in the market. However a large bar with a wide distance between the high and low price means that there has been a lot of buying and selling.

Candlestick chart

The Japanese candlestick chart shows the same information as a bar chart with the addition of a colour coded system. In the above illustration, green represents a bull market (a rise in the market) and red represents a bear market (a drop in the market).

Summary:

The open price: This is the price of the first transaction within a chosen time interval.

The close price: This is the price after the last transaction within a chosen time interval.

The high: This is the largest price recorded in a specific time interval.

The low: This is the lowest price recorded in a specific time interval.

15. How to Trade Forex

To start trading in the forex market, you must open an account with a trusted brokerage firm, add funds to that account that are available for investment purposes and then start trading.

Remember, the main analysis vehicles to make informed trading decisions are technical and fundamental analysis. One focuses on price action, and price patterns while the other on macroeconomic trends.

Before setting up an account, traders need to build their knowledge in the field and then use those analytical tools through a trading platform to speculate based on their research and developed skills.

16. How to Trade with a Forex Broker

The first thing to ensure about a forex broker is that they are regulated. This ensures that the brokerage firm is monitored, held accountable, and offers its clients the highest level of transparency.

FP Markets is a global financial technology service forex broker that follows the strictest international regulations set by ASIC, CySEC and ESMA and has been awarded the number one Value Global Forex Broker on multiple occasions. Below is a quick illustration of the steps required to open an account with FP Markets.

17. Risks in Forex Trading and How to Manage Them

Forex trading is a fast-paced and unpredictable environment. This means that it carries with it a level of risk which demands investors, especially beginners, to be well informed. Alternatively, they will be trading blindly and be at the mercy of social and natural events. Some risks include:

Transaction risks: Because forex trading occurs on a 24-hour basis, there is a risk of an exchange rate changing suddenly before a trade has been settled. Hence, the greater the time difference between entering and settling a contract, the greater the transactional risk.

Interest rate risks: Interest rates greatly affect the value of a country’s currency. High-interest rates attract investments because a stronger currency provides higher returns. On the contrary, a low interest encourages investors to withdraw.

Leverage risks: Market volatility and rapid changes can cause the balance of a trading account to change very quickly. If there are not sufficient funds available to maintain a position due to a sudden change, there is a risk that the position will be closed by the platform.

Finding a regulated broker that you can trust, starting with a demo account, continuously building your trading knowledge and using a protective stop-loss order are a few of the main ingredients that can help a trader manage their risk effectively. Risk tolerance also plays an important role. The more experienced the trader, the more comfortable they are making investments because their expertise in the field provides them with the necessary information to make confident decisions.

Remember, when trading currency pairs, an investor needs to understand both sides of the coin. Events that influence the base currency is as important as knowing what events affect the counter currency.

18. Online Trading Platforms You Can Trust

FP Markets trading platforms like MetaTrader 4 (MT4) , MetaTrader 5 (MT5) and Iress are designed for high-performance and advanced functionality. They provide traders with ultra-fast execution, the finest market insights and analysis signals, advanced charting tools and technical indicators, all tailored to a trader’s financial needs.

References

Tatiana Freitas, M. D. (2022, January 11). Brazil’s Extreme Weather Is Flooding Mines, Drying Up Crops. Retrieved from Bloomberg : https://www.bloomberg.com/news/articles/2022-01-11/brazil-s-extreme-weather-is-flooding-mines-drying-up-crops

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