Forex Trading Basics and How It Works
Forex trading is becoming more popular in the recent years due in part to the fact that it is more accessible to the general public. It used to be that the currency market was the province of institutions and the wealthy, but technology and other factors have made forex investing, like other types of investing, more accessible to a wider audience. However, it is important to note that forex trading is rather risky, and the currency market is quite volatile. If you have the risk tolerance for trading currencies, and you are good at it, you can make a great deal of money. Conversely, it is also possible to lose a great deal of money in the forex market.
Image via Wikimedia Commons
How the Forex Market Works
First of all, it helps to known how the forex market works. “Forex” is short for “foreign exchange.” This is the market in which currencies are exchanged with each other. The forex market consists of foreign banks and institutions both financial and otherwise. $1 trillion a day exchanges hands on the forex market, and it is the most liquid market in the world. The market opens on Sunday evening at 5 p.m. Eastern, and trading happens 24 hours a day until it closes on Friday at 5 p.m.
When you invest in currencies, you really aren’t investing at all. Rather, you are speculating, trying to figure out how one currency will move relative to another currency. You don’t actually buy or sell anything, although when you are reading about the currency market all of the language used is that of investing.
There is no physical exchange of currencies when you “trade” on the forex market. Transactions on the currency market resemble electronic over the counter transactions. You have to go through institutions known as market makers in order to participate. Market makers set bid-offer prices, and you make a profit if you correctly guess how a currency will move against another one, and manage to overcome the spread between the bid price and the offer price. The market makers make money on the spread, so once you overcome that, you make nothing but profit — no transaction fees, no commissions.
Currency Quotes, Currency Pairs, and Cross Currencies
If you are going to trade in any market, you need to know how things are set up, and how the trading works. With the currency market, everything is done in pairs. Currency quotes consist of expressing how one currency is doing against another. For example, you might see a quote that looks something like this: GBP/USD 1.6643. As you can see, quotes are often expressed to the fourth decimal place. The exception to the rule is the Japanese yen, as the USD/JPY pair is only expressed to two decimal places. This is because the smallest changes can mean a big difference. You will hear of a “pip“, which is a “percentage in point” — the smallest price change available.
In the quote above, the Great Britain pound is considered the base currency. It is seen as the currency as rising or falling. So, when you are told that GBP/USD is rising, it means that the pound is gaining against the U.S. dollar. The second currency is called the quote or counter currency. The currency quote above indicates that, at the time of the quote, the pound is worth US $1.66. It takes $1.66 to equal one pound, so the pound is valued more highly relative to the dollar.
Here are some of the more popular currency pairs, and the nicknames that you might see when reading forex news:
- EUR/USD (Euro/U.S. dollar): Fiber — the dollar is often referred to as greenback.
- GBP/USD (Great Britain pound/U.S. dollar): Cable — the pound is often called sterling.
- USD/JPY (U.S. dollar/Japanese yen)
- USD/CHF (U.S. dollar/Swiss franc) — the franc is often called Swissie.
- USD/AUD (U.S. dollar/Australian dollar) — the Australian dollar is nicknamed Aussie.
- USD/CAD (U.S. dollar/Canadian dollar) — the Canadian dollar is called the loonie.
- USD/NZD (U.S. dollar/Canadian dollar) — the New Zealand dollar is called the kiwi.
Currency pairs that do not include the U.S. dollar, such as GBP/JPY, are known as cross currencies. It used to be that all currencies had to be converted to dollars before they could be exchanged. So the pound would have to be changed into dollars, and then those dollars changed into yen. But in recent years, that has changed and it is much easier trade cross currencies.
Using Leverage on the Currency Market
Forex trading is profitable because leverage is an integral part of the process. Many market makers will offer you the ability to make use of 400 – 1 leverage. This means that $1,000 will control a position that is worth $400,000. You can quickly see how a minuscule change in a currency pair can result in huge profits (or losses). For the most part, forex currency positions are controlled in lot sizes of $100,000. However, there are some forex brokers that offer “mini forex accounts” that allow you to control smaller sizes of $10,000. This can limit some of your losses (and your profits). Most brokers require that you open a regular forex account with $2,500, or a mini account with $250.
Currency trading is quite risky. Political events, economic news and investor perception can change the direction a currency pair is moving quickly. This means that you can find your winning position quickly turning into a losing position. Many people instead choose to limit their risk by investing in currency ETFs or taking small profits as they arise.
How to Get Started with Forex Trading
If you are interested in learning more about forex trading, there are several forex brokers that offer a free trading simulator where you can try your hands on forex trading using virtual money. For example, Zecco Forex part of the famed Zecco Trading is offering a free $50,000 practice currency trading account. You can easily sign up and try it out with no obligation.
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market image, Investing, forex market, Forex, currency market, Risk Tolerance, foreign banks, currencies, forex tradingRecommended articles
All posts by Miranda Marquit (Staff Writer)
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I came very close to trading forex, but then just lost interest. I lost interest because I didn’t realize that there are only a few pairs that you can engage in, and not a lot of currencies can be traded.
It really depends on the site you use. There are some brokers that offer 150 or more currency pairs. However, there might be additional restrictions for some of the more exotic pairs.
it seems like a speculators dream come true. I had heard about this type of “investing” but never really put myself to researching about it. But the speculation part of it makes me really shy away from it because there is no way of analysing and managing risk- which is an integral skill for a long term investor. While i have a stomach for risk, it weakens considerably when i start taking guesses on which way the world economy will move. Give me the more manageable stock market and real estate and business building. These would make me sleep easier. Nice post by the way- has really summarised the whole thing for me nicely
Nothing personal Miranda, but this article is full of inaccuracies:
– The currency market is no more volatile than any other. In fact, when you compare it to the likes of individual stocks and commodities it can be quite a bit less volatile. On average it’s probably about the same as stock indices. People wrongly make this more volatile claim all the time because they look at the impact of applied leverage to profits and losses rather than what the actual prices are doing.
– The most recent data I’ve seen from the BIS indicates that forex trading exceeds $3trln in daily volume.
– None of the “language used” in forex trading is related to investing. Forex market participants are well aware that they are trading and don’t make any claims of it being investing.
- Not all forex brokers are market makers. There are those who are straight through brokers who don’t make money on the spread. They charge commissions, so to say there are none is inaccurate.
- No forex market professional calls EUR/USD “fiber”.
- GBP/JPY, ect. are known as “crosses”, not “cross currencies”. Also, I’ve been in forex since the middle 90s and can say that crosses have traded in their own right for at least that long, and no doubt longer.
- Forex trading is not profitable because of leverage. Leverage simply enhances profits (and losses)
- 400:1 leverage is not commonplace. In fact, at the end of this month the NFA will be requiring all member US brokers (which is most of the major firms) to cap leverage at 100:1 for the major pairs and crosses, 25:1 for the more exotic pairs.
- A standard lot is 100,000 units of the base currency, so not necessarily $. Mini lots (10,000 units) and micro lots (1000 units) are readily available. There are also brokers with no fixed lot sizes.
John Forman
Senior Forex Analyst – Thomson Reuters IFR Markets
kenyantykoon – No way of analysing and managing risk? There is as much opportunity to do so in forex as there is in any other market.
Thanks for clearing up some of the issues in the article. I am not a forex professional, though I do enjoy a little speculation with a mini account.
It is true that many do use trading language, although they understand that it is not trading. Such terms as “buy” and “sell” are used when reading news and reports, even though nothing is bought or sold. And I have seen “fiber” used in reports from Europe, although it may not be professional jargon. I should have clarified that lots are in currency units, not dollars. And I have seen the term “cross currencies” used as well as “crosses”.
There’s definitely a lot of money in this, but as you say A LOT of risk, not something I recommend for online newbies looking to make a quick buck.. Lots of other good alternatives that you have also reviewed on this site.
Buy/sell is used by traders in all markets interchangeably with long/short. You’re right that it should be going long/short in forex (and futures), but what are you going to do? The traders know they aren’t actually buying or selling anything (except when you’re at the inter-market level where corporations are actually doing real exchanges).
Your reference to “fiber” is, I believe, only the second time in the 10+ years since the euro was launched that I’ve ever seen that term, and I think the other one was someone asking if it was commonly used. It is definitely not anywhere near common parlance, even among retail traders, with whom I also regularly converse. It’s probably used by the same folks who say “the forex”, which is another phrase you’ll never hear from a pro.
As for “cross currencies”, those who are using that term are mangling the English language (like the folks using “the forex”). There is no such thing as a cross currency. There are currencies, and there are cross rates between currencies. Technially speaking, all exchange rates are crosses or cross rates or cross pairs, though generally speaking that term is only applied to pairs not including the USD.
Fredrik – Risk is a function of the way someone trades, not the market traded. If you traded forex with zero leverage (yes, it’s possible) you would likely see lower portfolio volatility than if you traded stocks.
With the way the dollar is moving against the Euro and the way Sterling is moving against the Euro, and the movement of gold, this is a very interesting (and potentially lucrative) time to be dabbling in forex
Totaly agree , Ive been making a full time living from Forex for 5 years now , I make more in a month then i use to in a year now.
@Manchu, I feel you. I also lost interest when I was just starting with forex at Etoro forex trading. But then I read some articles and miraculously, it made me understand.