A Quick Guide on How Does Forex Trading Works

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Forex trading refers to buying and selling currencies at current or predetermined prices to make a profit. It’s the largest financial market in the world with an average trading volume of 4.5 trillion per day. The main players in the market include hedge funds, banks, pension funds, and businesses with huge capital. Unlike commodities or shares, foreign exchange trading takes place in the over-the-counter market. As long as you have the basic knowledge and experience, you can pick up very quickly. Here is a detailed guide on how forex trading works. Buckle up and be ready to be impressed.

Currency pairs

The concept of foreign exchange trading involves buying and selling of currency pairs through a broker or a dealer. They are divided as majors and cross-currency pairs. Examples of major currencies include EUR/USD, USD/CAD, AUD/USD, GBP/USD, and USD/JPY. The first currency listed in the pair is the base currency while the second one is the quote currency. Ideally, currencies are quoted in pairs where you buy one currency in order to sell the other. For example, USD/CAD is a currency pair that involves buying the US dollar and selling the Canadian currency. If this currency pair is trading at 1.1300, then one Euro is worth 1.1300 dollars. Similarly, if one Euro rises against the dollar, the pair’s price will increase.

how forex trading works

The cross-currency or minor currency pairs are less frequently traded. They feature two major currencies without the US dollar. Examples include GBP/JPY, EUR/CHF, EUR/GBP, among others. Keep in mind that the transaction costs of minor currency are always higher. If you think the quote currency will strengthen against the base currency, you should sell the pair (go short). When you begin to trade online, you may be overwhelmed by the many currency pairs. It’s important that you study the best pairs that fit in your trading strategy.

Related: Major Currency Pairs EURUSD, USDJPY, GBPUSD Characteristics

What moves the foreign exchange market?

While there are many factors that contribute to price movements, the market is primarily driven by demand and supply. Consider this scenario. If the demand for a currency pair increases, the sellers are taken out. And once the prices reach a specific threshold, they attract new sellers into the market. More clearly, if buyers and sellers are at equilibrium, the prices range. Another contributing factor is the central banks. If they announce measures that affect a specific currency, the price changes. Ideally, central banks try to control inflation, money supply, and interest rates. Thirdly, the market is largely affected by news reports. Depending on the economic calendar, you’ll find high impact news, low impact news, and medium impact news. Positive news report increases the value of a currency while negative report lowers the currency’s price.

Spread, lot size, and leverage

The difference between ask and bid price of a currency pair is called spread. To put it succinctly, it’s the cost of trading currencies. If the bid of GBP/USD is 1.4048 and the asking price is 1.4050, then the spread is 0.2. This means that as soon as you open a position, you’ll incur a cost of 0.2. It’s worth mentioning that the spread will depend on what the broker offers. Also, the spread is influenced by the volatility in the market. High-impact news during the trading sessions will always widen the spread. If you’re a new trader, you should keep an eye on spreads as they can easily cause a margin call.

On the other hand, a lot size is the number of currency units you buy or sell. A standard lot consists of 100,000 units of currency. You should trade a specific amount of lots to realize significant change in profit or loss. Let’s assume you use the standard lot size (100,000 units). If you trade EUR/USD at 1.2150, you’ll get $10 per pip.

In forex trading, you’re basically borrowing one currency to trade the other one. This gives you a chance to gain exposure on large sums of currency without paying for the full value upfront. While high leverage can magnify the profits, it can also lead to loses.

Understanding the different types of forex exchange markets

Before you venture into foreign exchange trading, you should know the trading sessions in different time zones. They include London, Sydney, New York, and Tokyo. The forex market is available 24 hours a day which means you can trade at any time of the day. If you’re a beginner, you should know the best time zones to increase your odds of success. The London market opens at around 3:00 a.m. and runs until 12 noon EST. It’s then followed by New York which runs from 8:00 a.m. up to 5 p.m. Eastern time. Sydney and Tokyo sessions open at 5.00 p.m. and 7 p.m. respectively. As a beginner, you should trade when two trading sessions overlap each other. During such times, the market presents the best trading opportunities. Be cautious about opening a position at the beginning of a session. It’s better you wait for it to heat up before executing a trade.

What do you need to trade forex ?

If you want to start trading in the foreign exchange market, you should choose a broker, trading platform, and ensure you have internet access. This inherent flexibility has led to an exponential increase in the number of participants. You can open the market with just a few dollars and make some money out of these.

We can’t deny the fact that competition among online forex brokers is fierce. When choosing a broker, you should consider several factors like regulation, account minimum, commission, account fees, promotions, and platform features. Profitable forex investing requires that you choose a service that aligns to your investment needs. Generally speaking, the broker should be highly regulated.

The second most important factor is the trading platform. Most brokers offer web platform, MT4 and MT5. Metatrader 4 has all the features you need as a retail trader and is user-friendly. Metatrader 5 is the newest trading platform that integrates all the tools for successful trading. You can use the indicators, stop losses and take profit. The key factors to look for in a platform include safety of funds, trading conditions, reliability, and licensing. Once you deposit the money, all the currency pairs will reflect on the platform and you can begin your trading.

Final words

The forex market works the same way as trading assets such as bonds, stocks, and commodities. With the right knowledge about the financial markets, you can make money in the long-run. The mechanics are straightforward since there’s no centralized exchange to trade currencies. But before you invest your money, you can trade the demo account to harness your skills.

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