How Does Forex Trading Work?

To the average person, forex, otherwise known as foreign exchange or simply FX, is one of most enigmatic trading markets in the world. Seemingly contained among the elite banks of the world, why would an average person ever want to venture into the Forex market?

Forex Market

First, we will explore the basics of how this market works. Forex is a market for currency trading. Nearly every currency in the world is traded in pairs against other currencies — for example, the EUR/USD, USD/JPY, or EUR/GBP pairs. These transactions take place on various exchanges spread out across the world, the primary ones being New York, London, Sydney, and Tokyo. Consequently, the forex market is trading 24 hour/day, because there is always an exchange open, and oftentimes two or more at a time. The market does close for several hours each weekend.

Currency Pairs

Now what exactly are “pairs”? The FX market is made up of hundreds of currency pairs, each functioning much like a share of stock. They are essentially the demarcation of the exchange rate between two currencies. The first currency of a pair is the base; for example, in the pair “EUR/USD,” the Euro is the baseline. Each pair is usually coupled with the latest quote, looking something like this —

EUR/USD 1.2658

The first part is obviously the pair and the second is what is referred to as the “quote.” Essentially it tells you, “You can get x USD for 1 EUR,” or “for each 1 of the base currency, you can get x of the second currency.”

Forex Trading

Now that we understand the basics of the market, we can explore how to trade on it. Knowing that that market is composed of multiple exchanges, you probably realize you have to have a method to connect to it. Before the age of the Internet this was a nearly impossible market to use for the common man. However, with the explosion of home Internet usage, many brokers take advantage of it to offer the layman real-time quotes, and the opportunity to trade on this lucrative market. The key to avoiding fraud is picking the right forex broker.

In order for a layman to enter the market, he must either have an immense amount of cash — most currencies trade at the 3rd or 4th decimal place — or a very large margin. The latter is what most forex brokers provide — up to 400x leverage.

Forex Trading Risks

Because of the high interest in the market and the largely deregulated nature, there are many opportunities for fraud. However, most of these fraudulent activities occur at the brokerage level. The Refco corporation was a high-profile example of brokerage level fraud. On the other hand, because of the sheer size and number of transactions, the FX market is impossible to “pump-and-dump,” which in turn shelters most people from fraud.

Forex is a high risk/high reward scenario: exhilarating at one moment and barely budging the next. Take a good look at the foreign exchange market — it’s not right for everyone — but there may be something there for you.

About the Author

By , on Apr 12, 2010
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the owner and publisher of WorkSaveLive.com.

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Leave Your Comment (2 Comments)

  1. Lorne Marr says:

    Well, Forex is a big hit, everybody wants to get involved, from college students to our grandmothers. You can earn hundreds of percents spending just some dollars and using the almighty leverage, isn’t that great? Not so much…

  2. John Forman says:

    Not to make this anything personal, but I have to say this is about the worst article about the forex market I’ve ever read. The author loses all credibility from the outset when he says “These transactions take place on various exchanges spread out across the world…” That one statement demonstrates a complete lack of understanding about the forex market. Point of fact, currency trading is primarily an over-the-counter market, not an exchange-traded one. The only exchange-trade forex action is in the futures market, which is only a small fraction of the total currency volume traded daily.

    Also, a currency pair is nothing like a stock. They are entirely different animals. A stock is a representation of ownership. A currency pair is a relationship between two currencies. The implications of that difference are enormous.

    I won’t even go into the last couple sections. I have no idea what the author was trying to say there.

    John Forman
    Senior Foreign Exchange Analyst

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