What is Forex Trading & How does it work?

The global money market where currencies are bought and sold in return for another simultaneously is what we call foreign exchange or, simply, forex.

Every time you travel abroad, you need to exchange your local currency with the currency of the destination country at prevailing exchange rates. Each time you exchange a currency the amount paid is very likely to be different. This difference can be speculated to make profits and losses on currency exchange in short term.

currencies are always traded in pairs. To buy or sell any currency, another currency needs to be exchanged. EUR/USD is the most traded currency pair in the world.

Forex is the world’s largest financial market in terms of volume, more than the commodities and stocks volume combined in daily transactions. According to the 2019 Triennial Central Bank Survey, the daily trading volume of the forex market is more than 6.6 trillion US dollars.

Another distinctive feature of the forex market is the unavailability of any physical location or a centralized exchange system. Instead, it runs on an electronic network of various banks, companies, individuals, and other entities. The currency market does not have any physical exchange, this market works 24 hours a day and five days a week.

The Basics Of Currency Trading

Since the dawn of Mesopotamian civilization 5000 years ago, people started to use money (coins) for exchange. The world has evolved into different nation-states. Now every country has its currency. So any currency supported by an existing government can be traded in return for others in the forex market.

However, not all national currencies are the same. Some are traded more frequently than others. For example, the bulk of forex trading happens in seven currencies: USD, EUR, JPY, GBP, CHF, CAD, and AUD. The rest of the national currencies are referred to as either minor or exotic. Most experts may advise beginners to stay away from exotic currencies.

Every national currency is indicated with the first three letters; the first two identify the country and the last one, its currency. For instance, in USD, the US is the United States and D for dollars. Forex trade requires two different currencies, buying and selling. When you start learning about the money market, you will come across various trader’s terms such as pairs, crosses, majors, minors, exotics, and so on.

The currency pairs

A forex trade always happens in a pair. You sell one currency in exchange for another. A forex broker is the middle link that connects the retail buyers and sellers with liquidity providers or each other. They quote a pair in the relative value of one another. For instance, if USD/EUR is mentioned as 0.8400 at the market price. This means one USD equals 0.84 Euro.

But you might ask why national currencies are valued differently. Well, factors range from the health of an economy and interest rate to market sentiments and others. We will touch upon these later; let’s focus now on major currency pairs. As you have guessed, it consists of currencies from major economies like the US, Japan, UK, and others.

Major Currency Pairs

Major currency pairs always involve the USD. Therefore, these seven pairs are most traded in the forex.

Pair	Countries/Region
USD/EUR	US and European Union
USD/JPY	US and Japan
USD/GBP	US and Britain
CAD/USD	Canada and the US
USD/AUD	US and Australia
NZD/USD	New Zealand and the US

 

These currency pairs dominate the forex market and are also the most liquid. Liquidity in forex is defined as the activity in the market. If a significant number of traders are dealing in these currencies, they are the most traded currencies and have a much bigger volume than other pairs. For instance, USD/EUR is forex traders’ favorite and more liquid than AUD/USD.

Cross-currency pairs (Minors)

Those major currency pairs without US dollars are often called “minors” or “crosses.” The most-traded crosses include EUR, GBP, and JPY. Although they are not as liquid as major pairs, they provide many opportunities to profit from trading.

Examples include:

Crosses (Minor Currency pairs)	Countries and Region
EUR/GBP	Europe and Great Britain
EUR/CAD	Europe and Canada
EUR/JPY	Europe and Japan
GBP/AUD	Great Britain and Australia
AUD/CAD	Australia and Canada
CAD/CHF	Canada and Switzerland

 

Exotic Pairs

In the forex market, exotic currency pairs can fluctuate. Combining one major currency with a currency from a developing country forms an exotic currency pair. For example, the pairing of the USD and Brazilian currency is a good example.

Some other examples include:

Currency Pair	Country/Region
USD/BRL	US and Brazil
ZAR/USD	South Africa and the US
RUB/USD	Russia and the US
EUR/THB	Europe and Thailand
EUR/PLN	Europe and Poland

 

Unlike major currency pairs where the spread is tighter, the exotic pairs can have twice or thrice the USD/JPY spread. They are also relatively less liquid than crosses. They are also more susceptible to market changes, economic, and geopolitical developments.

The most recent example is the Venezuelan currency, which was nosedived to an extremely low level. So be careful when you decide to deal in exotic. It is advisable for beginners to gain some experience before trading with exotic pairs.

Who is a Forex Trader?

The short answer is anyone with the intention of making profit by exchanging his money for another national currency in a short tenure is a forex trader.

However, there are two broad categories of traders i.e. entities and individuals. Entities participating in the forex market for buying and selling goods and services globally. For instance, when a European company buys raw materials from China, it must pay in Chinese currency, the yuan. But this is just a small percentage of daily forex volume. This trading is called hedging.

The leading forex traders are global liquidity providers such as banks, hedge funds, HNI, financial institutions, and others. Unlike businesses, this group trade for profit or speculation. Although retail trading has grown exponentially in the last few decades, they still take a tiny percentage of global forex trading volume.

Today, a wide range of players from banks to online retail traders either speculate on a currency pair’s price movements or hedge their exposure in other markets to reduce the risk of currency movements.

Methods to Trade Forex

Forex trading requires financial instruments. Each instrument is designed for a specific type of investor and trader.

For instance, Swaps and Forwards are mostly used by institutional traders to buy and sell currencies. Futures, Options, ETFs, and Spot FX are other important trading instruments. If you’re interested in retail trading, Spot FX is the way to go. Let’s look at some practical financial tools before we return to our main agenda, Spot FX.

Currency Future:

A futures contract is an agreement to purchase or sell a specific volume of currencies at a defined price on a specified future date. Futures are a type of derivative that helps protect against fluctuations in currency prices.

For example, if you think the EURO will rise in value relative to the USD, you can buy a futures contract to lock in the current, lower EURO price. This is an advantage for investors who want to hedge their bets and not be exposed to the unknown risks of changes in currency prices.

The futures contracts are standardized and traded on a centralized exchange like Chicago Mercantile Exchange (CME). It is one of the few well-regulated trading instruments in forex.

Currency Forwards

A forward currency contract locks in the price of a currency for future exchange. A currency forward is a customized hedging strategy that does not need a cash advance from the investor. A currency forward offers additional benefits as well, such as the flexibility to set customized conditions for a certain amount and a specific maturity or delivery time.

Forward currency contracts are different from conventional hedging strategies such as currency futures and options since these contracts, among other things, usually involve upfront payments for margin needs and premium payments.

Nevertheless, a currency forward is inflexible, meaning that the contract buyer or seller will have a contractual duty if the “locked-in” rate is shown to be unfavorable. Therefore, financial institutions that deal in currency forwards must ask for a deposit from ordinary investors or smaller companies to offset the risk of non-delivery or non-settlement.

Currency ETFs

An ETF that invests in many currencies gives exposure to one or more currencies. Retailers may get forex exposure by investing in currency ETFs, which manage their investments without the additional hassles of placing individual transactions. Exchange-traded funds (ETFs) are suitable for speculating on currency markets, diversifying portfolios, and for currency risk mitigation.

Financial institutions establish and run the Exchange Traded Funds (ETFs), holding single or combination currencies. Then these funds are put on sale to the public. They are similar to stocks and are tightly regulated by financial commissions. However, like currency options, currency ETFs have the drawback of not being available 24 hours a day. ETFs also incur trading fees and other transaction costs.

Spot FX

The spot FX is the simultaneous sale and purchase of a currency at the current market prices. Unlike Options or Futures, it can be settled instantly.

• The current market price is also called the spot price.
• Many individuals worldwide prefer spot FX as it has a narrow spread and requires smaller initial amounts for trading.
• It is an over-the-counter (OTC) market meaning there is no centralized location for currency exchange.
• It also means that customers can directly trade with a counterparty.
• So, essentially, it is a private agreement between the two parties.
• Most spot trading happens over the electronic trading network.
• The primary market for spot trading is “interdealer,” where various forex dealers trade between them.
• A dealer acts as an intermediary that buys and sells currencies at any time. As banks are the leading players in the spot FX, it is also known as the “interbank” market.
• This market deals in bulk orders. That’s why only large financial institutions such as banks, insurances, pension funds, MNCs, and other holdings are part of spot FX trading.
• Interestingly, this currency trade is that you are buying or selling a contract, not the currencies themselves.

You enter into an agreement that specifies the agreed-upon price at which the deal will happen. For example, if you buy EUR/JPY on the spot, you will receive a fixed amount of Japanese yen in exchange for euros at the current market price.

The settlement of the agreement usually takes two working days before the payment. So it’s not such a simultaneous transaction as the name suggests. Also, remember that retail investors are not part of spot FX.

Retail FX

As most trading options are limited to institutional investors, retail FX trading allows ordinary people to trade in currencies. The retail FX providers are usually OTC dealers, brokers, and market markers.

What differentiates retail forex trading from other trading options is the availability of leverage. Leverage allows you to bet a large sum of money on trade with a tiny fraction of the total trade value.

For example, a broker can offer you a 1:20 leverage ratio. That means if you deposit USD 5000 in your trading account, you can open positions worth USD 100,000 trading order. Without leverage, you will need to deposit $100,000 to open a position worth $100,000.

Risking a deposit of $100,000 with a broker is not feasible or possible for retail traders. Hence, it is not possible for a common man to trade forex without leverage.

It might surprise you to know that nobody takes delivery of any currency in forex trading. As mentioned, you’re not trading any actual money; you are trading a contract.

This contract is unlike any other agreement, and it is a leveraged contract. Retail traders neither take nor makes any delivery of the leveraged spot forex contracts. Your trading volume is simply “rolled over.” More on this in the later segments.

CFD Trading

CFD stands for contract for difference. It is one of the most popular trading instruments among retail traders. A large brokerage house or liquidity provider can offer various trading opportunities in metals, currencies, commodities, indices, and more through CFDs.

CFDs are a type of derivative instrument. The value of a CFD depends upon the value of the underlying asset, which can be anything, a currency pair, or an equity index.

CFDs allow traders to speculate on price changes without owning the underlying asset. As a result, CFD traders can avoid some of the difficulties and expenses associated with conventional trading because they do not own the underlying asset. The profit and loss are determined by when you opened CFD buy or sell position and when you would close them multiplied by the number of CFD units.

CFD trading is the best method for retail traders to take the advantage of forex markets. CFD trading is legal in the UK and is regulated by the FCA of the UK. As per FCA regulatory compliance, the maximum leverage that a CFD broker can offer in the UK is 1:30. High leverage increases the risk factor.

Working of Forex Trading With Example

• Forex trading is easily accessible for retail traders through CFDs. CFD trading on forex pairs is regulated by FCA of the UK and traders are protected by up to GBP 85,000 per client in case of an unsettled dispute between broker and trader.
• Forex trading through CFD involves leverage capped at 1:30 for major pairs by the FCA of the UK. The max leverage for other pairs is 1:20 in the UK. All FCA-regulated brokers are bound to comply with FCA regulations.
• Traders need to open their accounts with an FCA-regulated broker. After that, they can place trading orders on available forex pairs through electronic trading platforms from electronic devices.
• Each broker has different trading conditions, offers different instruments, charges different fees, and supports different trading platforms.
• Brokers with STP/ECN execution method pass on the trade orders to the liquidity providers where orders are matched with other trade orders of opposite sides. The market maker can match opposite orders and can also take the other side of the trade themselves.
• After opening the position, traders can see the profits and loss amount on their trading platform as the price moves with time. Traders can also modify the take profit or stop loss after opening the position.
• On a long position of 1 standard lot, 1 pip upward price movement will generate a profit of $10. 1 pip downward movement will incur a loss of $10.
• Once the position is closed the profit amount will be added to the account equity and losses will be deducted from the same.

Should you Trade Forex Pairs?

The forex market involves financial risk. If high leverage is involved, the risk factor is further increased. More than 70% of forex traders lose money while trading forex pairs. However, experienced traders who trade with discipline, strategy, research, and analysis are likely to make profits in forex trading.

Almost every country is financially linked to each other. For instance, the US subprime lending crisis in 2008 affected most emerging economies. However, there is a silver lining in this interconnected world. And the mammoth forex trading volume is a testimony of that.

The free-floating regime provides numerous opportunities to make a profit from price changes in one currency against another. If you understand the basics of forex trading, you can also generate colossal profit.

However, profits cannot be made in capital markets without risk. Forex markets is highly risky and one must consider all the risk factors involved before starting to trade forex.

Benefits of Forex Trading

No middlemen and No commission

The ECN does away with mediators and hefty commissions. Also, online trading is free from any clearing fees and commissions if you trade with a market maker.

High Liquidity

FOREX is the world’s most liquid market, with an average trading volume of more than $6 trillion per day. It means that a trader can join or quit the market at any time and under nearly any market conditions.

24-hour market

The market that never sleeps can offer you significant advantages. For example, the forex market operates 24 hours from Australia to the US, five times a week. It means even part-time individuals can also trade, and pick any time, day or night.

Higher Leverage

Forex leverage allows trading with much more money than the trader has in their trading account. Forex brokers offer their clients different percentages of leverage, which means that, for example, a person who has $1,000 can trade with $10,000 worth of currency.

Both commercial and retail traders use leverage to increase their market exposure in order to profit from small price movements in their favour while limiting losses from unfavourable moves against them. The currency market has enormous volatility, which makes it challenging for traders to predict how much they can make on a trade.

The higher the leverage ratio you use, the more you’ll be able to make on any given transaction (or lose). Forex leverage provides an increased probability of success and increases your risk many times since losses can be huge when the trading order results in a loss. Therefore, leverage, although it maximizes the profit potential, can also lead to huge losses.

No entry barrier

You’d think that starting out as an FX trader would be extremely costly. The truth is that it does not when compared to trading stocks, options, or futures. Online brokers provide “mini” and “micro” trading accounts, with some requiring a $50 account investment.

No investment for the practice

Want to hone your trading skills but don’t want to put in any real money, then choose a demo account. Many online brokers offer a demo account with preloaded virtual money. Newcomers can take advantage of demo accounts before investing.

Limitations of Forex Trading

Following are the challenges or disadvantages of trading forex:

High Risk

Forex market is not ideal for many traders due to its high risk. The market risk in forex trading is much higher compared to other capital markets like stocks, commodities, etc. The involvement of leverage further increases the risk of losing a substantial amount within a few seconds.

The market is active 24 hours a day and any news event around the globe can affect the prices of currency pairs. Hence, at times it becomes impossible to correctly predict the price movement.

Lack of Transparency

There is no particular location from where the forex market is controlled or managed. Foreign currencies are exchanged in many ways mainly through central banks, private banks, large financial institutions, etc. The forex market is largely influenced by large-scale market makers, liquidity providers, and banks. Hence, there is no transparency about how the trade order is getting executed. The trading volume and market sentiment are also difficult to predict in the forex market.

Complex Valuation Method

The value of one currency in return for another keeps on changing due to multiple reasons at every minute. It is quite complex for retail traders to calculate the valuation of one currency in terms of another. The valuation depends on the economic and financial details of the involved currencies and their predictions. Compared to other capital markets, it is much more complex to do a valuation of the currencies.

Difficult to Learn

Stocks, commodities, and other markets are much easier to comprehend compared to the forex market. In the stock market, traders can get assistance from experts and portfolio managers. Comparatively, it is challenging to learn forex trading and understand the forex market. Traders have to learn most of the forex trading on their own.

Risk of Forex Trading

The following are the major components of risk factors involved in forex trading:

1. Leverage Risk
   High leverage allows traders to open bigger positions with smaller deposits but it will also increase the risk. In case if the price moves against the anticipation, traders with high leverage will face a higher % of loss and sometimes can also lose whole account equity.
2. Country Risk
   Each currency is used in different countries. The economic, geopolitical, or any other event in a country can affect the prices of its currency against other currencies. A country may face crises, floods, trade deficits, etc that can dramatically affect the prices of the currency pairs.
3. Counterparty Risk
   When you are making a deposit to a broker, your broker holds your possession. Some fake brokers can also run away with your deposits or put restrictions on withdrawals. This risk is also known as third-party risk and can be mitigated by choosing a regulated and trustworthy broker for forex trading.
4. Position Close Out
   When a large position is opened with a little amount left in the account balance, price movement against the anticipation will force close your trading position. This will lead to sudden closing of position in severe loss even when you don’t want to. The trading position can be closed before it reaches the stop-loss level.
5. Political and Socioeconomic Developments

Instances of political uncertainty, geopolitical conflicts, and shifts in economic conditions (such as elections, alterations in policies, and trade disagreements) possess the potential to induce abrupt and unforeseeable shifts in the market, resulting in notable financial setbacks.

6. Excessive Trading and Emotional-Based Choices

Engaging in excessive trading, characterized by an overabundance of transactions, and making judgments influenced by emotions rather than well-grounded analysis, can lead to unfavorable trading consequences and substantial monetary losses.

7. Psychological Risk
   Emotional decision-making can lead to impulsive trades and losses. It’s crucial to have a well-defined trading plan and stick to it.
8. Risk Management
   Failing to use risk management tools like stop-loss orders and take-profit orders can result in larger losses if the market moves against your position.
9. Account Size Risk
   Trading with an account that is too small in relation to the size of the trades can lead to margin calls and losses.

FAQs on What is Forex Trading