What Is Forex Trading, and How Does It Work?
- July 13, 2021
- Posted by: Daniel Richard
- Category: Forex Trading
Forex is one of the most traded markets in the world. It is the short form of Foreign Exchange and is also known as the FX market. It is an online marketplace for trading a currency to exchange 24 hours per day for five days per week. To have a successful financial deal, you should understand everything about Forex mentioned here.
What is Forex Trading?
Forex trading refers to exchanging or trading one currency to another that trades among buyers and sellers at an agreed price. When trading in Forex, you always buy one currency and also sell another. You can easily continue dealing from home since it is an online-based trading system.
You always find a three-letter code in the currency list. The first two letters indicate the region, and the last one is the currency itself. For instance, the US dollar has the code USD, and in the same way, the Japanese Yen has the code JPY. Thus, in this USD/JPY pair, you can sell the Japanese Yen to buy the US dollar.
Suppose you want to travel abroad, and you need the currency of the destination country. For this reason, you need to change your cash in exchange for the money of this country. And, this exchange is called Forex trading.
Forex is the globally largest, most liquid market of finance, which facilitates exchanging, selling, buying, and speculation of currency. In the currency pair, the first-named currency is the “base” currency, and the secondary currency is the “quote” currency.
While purchasing a currency from the broker, you sell the quote currency and buy the base currency. Similarly, while selling, you accept the quote currency and sell the base currency.
You find some kinds of currency pairs in the financial market. They are:
- Major Currency Pairs: Major currency pairs are the widely traded pairs in the forex market. These pairs include the USD or US dollar with other currencies. Generally, seven major currency pairs exist, such as USD/JPY, USD/CHF, USD/CAD, EUR/USD, GBP/USD, AUD/USD, and NZD/USD.
- Minor Currency Pairs: Minor pairs are not associated with the US dollar and not liquid like the major pairs. For example, GBP/JPY, EUR/CHF, and EUR/GBP.
- Exotic Currency Pairs: The pairs of exotic currency are not like liquid currency. For instance, USD/SGD (US dollar/Singapore dollar) is an exotic currency pair.
How Does the Forex Trading Work?
Similar to the stock market, there is no centralized exchange organization in the Forex market and no physical location. That’s why you can trade 24 hours a day. Three main things are most important for Forex trading, which are money, broker, and you. To be a successful Forex trader, you need to have proper knowledge about Forex trading.
You are part and parcel of Forex trading because trading is not possible without an individual. In the same way, money and brokers are crucial for trading. Moreover, trading is non-existent without these three essential components.
In a conventional over-the-counter (OTC) market, institutional Forex trading takes place directly between two parties. The trader can predict the direction depending on their thinking of currency pairs’ movement. If the prediction is correct and they trade according to their forecast, the trade will be profitable.
The Forex market is a global online market where investors and traders buy and sell their currencies. For the international payment system, the role of the Forex market is significant. There are some foreign exchange markets in the world-
Three Types of Forex Markets
Spot, forward, and futures markets are the three crucial foreign exchange markets globally.
- Spot Markets: It provides payment immediately to the buyers and sellers. According to the Bank of International Settlements estimation, the spot market exchanges 50 percent of all transactions in the FX markets daily.
- Forward Markets: Two parties agree to buy and sell contact at a future fixed date. At the time of signing a deal, no security deposit is required.
- Future Markets: Future markets give solutions for the problem of the forward market. Compared to the forward markets, the futures markets are highly liquid.
What is Leverage in the Forex Trading?
Leverage is one kind of loan taken from Forex brokers. It is a way for the traders to trade more volumes than their limited amount. The leverage size is not fixed. Instead, a particular broker selects the extent of leverage. Therefore, you can use your limited amount of currency as large volumes by the leverage. As a result, you can get a large amount of profit as well.
People may accept 1:500 or 1:1000 leverage, but the standard leverage is 1:100. If you invest 1000$ and you get 1:100 level, you will be able to use 100000$ for trading in forex. Though your deposit is not sufficient for trading, you can take an adequate amount from brokers.
Suppose you deposit 200 dollars, and your leverage is 1:1, which means you do not want to take any leverage. In this case, you cannot open any big trade, since the brokers will never allow opening a big trade with your 200 dollars. For this reason, you can get a minimal amount of profit.
The more leverage you will take, the more risk you will have. The broker never takes risks. If you invest $100 and accept leverage of 1:1000, your total trading amount will be $100000. But if you lose $100 from the total amount of $100000, the broker will close your account because they will never accept losses for the risks you have taken.
What is Margin in the FX Trading?
Margin is the most crucial concept to understand in the leverage Forex market. In a trader’s account, the margin is the amount of money that maintains and opens the leverage trading position. Margin is a popular strategy in foreign exchange trading because the use of leverage can be profitable here.
Before using leverage in the Forex market, you should take the time to understand how the margin works. It is essential to have a clear idea about maintenance margin, margin calls, and margin level.
So, the margin is the particular amount of money that the broker blocks from your deposited money. Suppose you deposit $2000 for opening a trade, and your broker blocked $200 from your total deposited amount. Here $200 is the margin.
Margin is basically calculated in percentages. The more leverage you take, the lower your margin will be. If you take 20:1 leverage, the broker will block 5% from your deposit amount, and if you take leverage 33:1, the broker will block 3%. You don’t get the margin until you close your trade. Basically, your broker uses the margin for taking your trading position when you trade.
What is a Pip in the Forex Trading?
Pip is the short form of ‘price interest point’ or ‘percentage in point’ that refers to a tiny change of currency pair in the foreign exchange market. In the Forex market, a single change of the fourth digit after the decimal point of a currency pair is called a pip.
For a clear concept, let’s see an example. You open a trade and see that the EUR/USD was 1.3640, and now it is 1.3645. How many chances do you find?
The rule is-
(Higher price – lower price)
= (1.3645 – 1.3640)
= 0.0005 pips
But it is exceptional for the Japanese Yen currency. For the JPY pair, it measures the movement of the second digit after the decimal point. So, if EUR/JPY moves from ¥137.239 to ¥137.249, It will change a single pip.
Pipettes: A single change of the fifth digit after the decimal point of currency pairs is called pipettes.
For example, the EUR/USD was 1.36445, and now it is 1.36447. So the pipettes –
(1.36447 – 1.36445)
= 0.00002 pipettes
Therefore, one pip equals ten pipettes.
What is the Spread in the Forex Trading?
In Forex trading, the spread is one kind of broker’s fee or commission. When you open a trade, you see that the trade opens with a loss. Brokers take a particular amount from the trader’s total amount as their commission, and this commission is called the spread.
For example, suppose, you buy 1.2345 in GBP/USD, but it opens 1.2347. So, the spread is two pips.
What Is A Lot In Forex Trading?
Generally, a lot is the total amount of currency in Forex trading that a trader wants to buy or sell. There are four types of lots in the Forex market, which are-
- Standard Lot
- Mini Lot
- Micro Lot, and
- Nano Lot.
The standard lot volume is 100000, a mini lot is 10000, a micro lot is 1000, and a nano lot is 100. For the standard lot size, one lot is equal to ten pips. Therefore, as a standard lot broker, if your currency rate is changed to five pips, your profit or loss amount will ultimately be 5×10 = 50.
In the same way, for the mini lot size, one lot is equal to one pip, and in a micro lot, one pip is equivalent to ten lots. So in a mini lot size, your profit or loss amount will be 1×5 = 5 for the change of five pips.
What Moves the Forex Market?
It is difficult to predict the exchange rate in the Forex market since there are so many reasons for changing the currency rate. The supply and demand can primarily influence the movement of the currency rate.
The central bank can control the supply, and supply influences the price movement. If the central bank supplies more money to the economy, the currency value will drop.
The currency rate depends on the news reports. Because of the positive news reports, the investors are encouraged to increase their demands, and if the demand rises, the supply will fall. As the supply increases, the currency rate will be high.
Market sentiment is critical for moving the currency rate. If the trader identifies that the currency follows a particular direction, they will trade according to the direction. It may increase or decrease the demand.
Economic data is influential for the movement of the currency rate. It indicates the performance of the economy and also what the central bank may do next.
For investment, the high credit rating area is safer than the low credit rating area. For an upgraded credit rating, the currency value increases.
The analysis method is crucial for the Forex market. You can fundamentally and technically analyze the foreign exchange market.
The fundamental analysis investigates how the overall social, economic, and political factors impact the Forex market and how changes are found in the currency rate for these impacts. You can also get an idea about the influence of demand and supply.
If the demand is greater than the supply, the value of the currency rate will increase. Similarly, the currency rate will decrease if the demand is smaller than the supply. Thus, by fundamental analysis, you can get a firm idea about a country’s economy and identify the currency rate that helps you determine the correct time for buying and selling.
Technical analysis is an essential analytical system in the Forex market. It is also named the chart analysis. You can analyze currency movement by technical analysis and identify possible future currency rates by analyzing the currency history.
Trend line is one of the most popular technical tools in Forex trading, which is easy to draw. A trend line connects all low points, and another trend line joins the upper points. The trend line breaks when a candle crosses the upper or lower lines.
Traders can also analyze the price level in the Forex market by using support and resistance tools. Support is a position of price level where there is no possibility to step down. On the other hand, resistance is a position of price level where there is no possibility to step up. So, traders buy the currency or assets in the support level position and sell these at the resistance level.
Therefore, if you have adequate knowledge about the Forex market, your trading will be profitable; otherwise, your trading may fall.