What Is Forex Trading And How Does It Work?

Forex Trading is the exchange of one currency for another currency.  For example exchanging your US Dollars for EUROS.  Explaining how Forex trading works is not as simple of an answer.  So lets dive deeper into the Forex market:

The reason the Forex market is a bit confusing is because you’re not buying anything physical like in the stock market.

To make it easy think of buying a currency like you are buying a share of a particular country, similar to when you buy stocks, you are buying a share of a company…..same thought process.

So, for starters can we agree that the price of the currency is usually a direct reflection of the market’s opinion of the current and future health of the economy that the currency represents?   Like if the United States Dollar is strong that is because the US economy is strong.

Well with Forex trading, when you buy, for example, the Great Britain Pound, you are basically buying a portion of the United Kingdom economy.  How cool is that?

You are basically saying that the United Kingdom economy is doing strong, and will even get stronger as time goes on. The goal is to sell those shares of the economy back to the market, in other words, exchange the Great Britain Pound for another currency for a profit.

So in essence, the exchange rate of a currency as compared to other currencies is a direct reflection of that country’s economy, when compared to other country’s economy.

Characteristics of Currencies “tickers”

Like stock symbols/tickers, currencies are known by their symbols.

Currency symbols are represented by three letters.  The first two letters correlate with the name of the country and the last letter is reflective of the name of that particular country’s currency.

Let’s look at an example....

JPY stands for Japanese Yen, JP obviously stands for Japan and the Y is reflective of the currency Japan uses which is the Yen.

Now we can  take this a bit further.  Currencies in the Forex market are categorized in 3 sub-groups.   These are the majors pairs, the major cross pairs, the exotics pairs.

The majors: are known as the majors because these are the currencies that are most widely traded pairs and have the USD on one end  of the traded pair.

The major crosses: are known as the major crosses because they are also most widely traded but do not have USD as a currency pair.  The currencies traded in this category consist of three of the major non-USD currencies: EURJPY, and GBP.

 

Ok so now hopefully you understand that Forex trading is simultaneously buying one currency and selling another. It is also vital  to know that currencies are traded through a broker, and again are always traded in pairs ie. Exchanging one currency for the other currency.

Characteristics of The Pairs:

The currency pairs that  are known as the “majors” have these characteristics:

  • These pairs all contain the U.S. dollar on one side
  • And are the most frequently traded

The major pairs are:

  • EUR/USD
  • USD/JPY
  • GBP/USD
  • USD/CHF
  • USD/CAD
  • AUD/USD
  • NZD/USD

Key point to remember:  The majors are the most liquid and widely traded currency pairs in the world!

We also have currency pairs that are known as Major cross currencies, minor pairs or crosses....same pairs just have 3 different terms they are known as.  These currency pairs do not involve the U.S. dollar (USD).

The most actively traded crosses are:

  • EUR
  • JPY
  • GBP

Here’s your common list of cross pairs:

EUR Crosses:

  • EUR/CHF
  • EUR/GBP
  • EUR/CAD
  • EUR/AUD
  • EUR/NZD

Yen Crosses:

  • EUR/JPY
  • GBP/JPY
  • CHF/JPY
  • CAD/JPY
  • AUD/JPY
  • NZD/JPY

GBP Crosses:

  • GBP/CHF
  • GBP/AUD
  • GBP/CAD
  • GBP/NZD

Then there are the exotic pairs.  Exotic currency pairs includes one major currency pair traded against the currency of an emerging economy, such as Mexico for instance (Mexican Peso).

Here is a few of exotic currency pairs for your reference:

  • USD/HKD-US Dollar/ Hong Kong
  • USD/MXN-US Dollar/Mexico
  • USD/ZAR-US Dollar/South Africa

Not all Forex brokers offer every exotic currency pair, so if you are interested in trading one of these currency pairs check with your broker platform prior to funding your account to ensure access.

Understand that these pairs aren’t as commonly traded as the “majors” or “crosses,” meaning the transaction costs to trade these pairs are typically higher.  And spreads may be two or three times bigger than that of a major pair such EUR/USD or USD/JPY. If you are interested in trading any of the exotics pairs, remember to factor this in your trading decision.

Forex Market Size And Liquidity

It is important to that the Forex market has neither a physical location nor a central exchange.  This is different than many other financial markets.

The Forex market is considered an Over-the-Counter (OTC), or Interbank market because of the fact that this entire market is run electronically, within a network of banks, continuously for 24 hours.

So in other words the Forex market is spread all over the globe with no central location. Trades can take place anytime, anywhere as long you have an Internet connection and a computer, table or smart phone!

The Forex OTC market is easily the biggest and most popular financial market in the world and it is traded globally by a large number of individual or retail traders and organizations.

Benefits of Trading in an OTC Market

In the OTC market, traders determine who they want to trade with depending on trading conditions, price action, and how comfort the trader is with the chosen currency pair.

The 7 most actively traded currencies are: USD, EUR, JPY, GBP, AUD, CAD, and CHF

The US dollar is by far the most traded currency, taking up at least 85% of all transactions.

The EUR comes in second being involved in approximately 40% of transactions, and then there is my favorite the YEN which is said to be involved in about 20% of all transactions.

Of Course, The Dollar is King this is especially reflected in the Forex Market

As you can see U.S. dollar (USD) in involved in nearly all currency trading.

Since the U.S. dollar is on one side of every major currency pair (see majors above), AND because the majors include over 75% of all trading transactions, it is very important to pay attention to the U.S. dollar.  It’s worth saying it again The US Dollar is King!


It’s safe to say that since, almost every investor, business, and central bank owns the US dollar, they pay close attention to it.

Other reasons why the U.S. dollar is so important in the Forex market are:

  1. The United States economy is the LARGEST economy in the world.
  2. The U.S. dollar is the reserve currency of the world.
  3. The United States has the largest and most liquid financial markets in the world.
  4. The United States has a stable political system.
  5. The United States is the world’s sole military superpower.
  6. The U.S. dollar is the medium of exchange for many international transactions. i.e oil is priced in U.S. dollars aka “petrodollars.” This means if Brazil wants to buy oil from Saudi Arabia, it can only be bought with U.S. dollar. If Brazil doesn’t have any US dollars, it has to sell its Real and buy U.S. dollars to complete the purchase.

Speculation in the Forex Market

It is also important to note that even though the Forex market is commercial and financial transactions are part of the trading volume, most of the trading is based on speculation.  Forex indeed is a speculatory market.

In other words, most of the trading volume comes from traders that buy and sell based on intraday price movements.

The trading volume brought about by speculators is estimated to be more than 90%!

The gauge of the Forex market means that liquidity – the amount of buying and selling volume happening at any given time – is extremely high.  This makes it very easy for anyone to buy and sell currencies in this market.  For a trader, liquidity is very important because it determines how easily price can change over a given time period.  A liquid market such as Forex enables huge trading volumes to happen with very little effect on price, or price action.

While the Forex market is relatively very liquid, the market depth could change depending on the currency pair and time of day.

Because Forex is such a perfect market for trading, traders has came up with a variety of different ways to invest or speculate in currencies.

Among these, the most popular ones are:

  • Spot Forex Trading,
  • Currency futures,
  • Currency options,
  • Currency exchange-traded funds (or ETFs).

Currency Futures

Futures are contracts to buy or sell a certain asset at a specified price on a future date hence the name futures.

FX futures were created by the Chicago Mercantile Exchange (CME) back in the1970’s.

Since futures contracts are standardized and traded on a centralized exchange, the market is very transparent and well-regulated. This means that price and transaction information are always readily available.

Currency Options

An “option” is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date.

If a trader “sold” an option, then he or she would be obliged to buy or sell an asset at a specific price at the expiration date.

Just like futures, options are also traded on an exchange, such as the Chicago Mercantile Exchange (CME).

However, the disadvantage in trading Forex options is that market hours are limited for certain options and the liquidity is not nearly as great as the futures or spot market.

Currency ETFs

Exchange-traded funds or ETFs are the youngest members of the Forex world.  A currency ETF consists of a single currency or basket of currencies.

ETFs are created and managed by financial institutions who buy and hold currencies in a fund. They then offer shares of the fund to the public on an exchange allowing you to buy and trade these shares just like stocks.

Like currency options, the limitation in trading currency ETFs is that the market isn’t open 24 hours.  Also, ETFs are subject to trading commissions and other transaction costs.

Spot Forex Market

In the spot market, currencies are traded immediately or on the spot, using the current market price. What’s so great about this market is that it is simple, liquid, have tight spreads and round-the-clock trading.

It’s very easy to participate in this market since accounts can be opened with very little money, less than $100.00 typically.

In addition to that, most Forex brokers usually provide charts, news, and research within their platform.

Why Trade Forex?

There are various benefits and advantages of trading Forex.  Here some reasons why so many people choose to trade in this market:

Low and Sometimes No Commissions

Forex has NO clearing fees, NO exchange fees, NO government fees, LOW or NO brokerage fees. Most retail brokers are compensated for their services through what is called the bid/ask spread.

No Middlemen

With spot trading there is no need for the middlemen.  This allows you to trade directly with the market responsible for the pricing on a particular currency pair.

No Fixed Lot Size

In the futures markets, lot size are determined by the exchanges.  In spot Forex, the trader determines your own lot size. This allows you to participate with small starting capital if you choose to do so.

Low Transaction Costs

For the retail trader cost  in the form of the spread, is typically less than a pip for major and cross pairs, under normal market conditions. The spread tends to be much higher for exotics so keep that in mind when selecting pairs to trade.

A 24-hour Market

Another attraction to the Forex market is that there is no waiting for the opening bell. From the Monday morning opening in Australia market to the afternoon close of the New York session, the Forex market never sleeps.  You could literally trade 5 ½ days a week.

This is a great incentive for those who want to trade part-time basis because you can choose when you want to trade: morning, noon, night, even while you’re sleeping.

No one entity can control the market

The foreign exchange market is so huge and has so many participants that no single entity not even a central bank can control the market price for an prolonged period of time.

Leverage

In Forex trading, a small deposit can control a much larger total contract value. Leverage gives the trader the ability to make huge profits, with less money.

For example, a Forex broker may offer 50-to-1 leverage, which means that a $100 margin deposit would enable a trader to buy or sell $5,000 worth of currencies. Similarly, with $1000, you could trade as if you deposited $50,000 and so on.

But, let’s remember that leverage IS very much a double-edged sword. Without proper risk management, this high degree of leverage can indeed lead to large gains but also lead to large losses.

High Liquidity

Because the Forex market such an enormous market, it is also extremely liquid. This is for your advantage though,  because it means that under normal market conditions, with a click of a mouse you can instantaneously buy and sell at any time, there will usually be someone in the market willing to take the other side of your trade.

You can never be stuck in a trade. You can set your online trading platform to automatically close your position once your desired profit level if you want when what is known as a limit order has been reached, and/or close a trade if a trade is going against you which is known as a stop loss.

Low Barriers to Entry

You would think that getting started as a currency trader would cost a significant amount of money. The fact is, when compared to trading stocks, options or futures, it doesn’t. Online Forex brokers offer nano, mini and micro trading lots, some with a minimum account deposit as low as $25.

Although it is not suggested that you open an account with the minimum, but having that option does make Forex trading much more accessible to the average individual that doesn't have a lot of start-up trading capital.

Most online Forex brokers offer demo accounts to practice trading and build your skills, in real-time trading conditions.  They usually will offer Forex news and charting services as well.

Demo accounts are so valuable for those who lack the experience and skill that is needed to be successful in the Forex market.  Demo accounts are perfect to those that would like to perfect their trading skills with play money before opening a live trading account and risking their hard earned money.

So now you know a little about what Forex trading is about.  Continue to read other posts to gain deeper knowledge of the Forex market.  With time the concepts of Forex trading will become clearer.

Now that I  have explained what Forex trading is, let's explore why I think Forex trading is one of the best ways to build wealth! This is why I think you should trade Forex.... 

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