what-is-forex-trading

Although you may not be aware of it, you may have been involved in the foreign exchange market one way or another, especially if you have traveled abroad before or ordered an item from another country.

Whatever the case was, you must have exchanged your local currency directly to the currency of the other country, or you first exchanged your local currency to USD and then to the currency of the country of interest.

But forex trading goes beyond that. A huge number of individuals, banks, hedge funds, and corporations trade the market to make profits. 

The forex market, also known as the foreign exchange market, is the biggest financial market in the world.

In fact, with a daily volume of more than $5 trillion, it is even bigger than the stock market, which trades a total of about $84 billion per day worldwide — according to the Triennial Central Bank Survey of FX and OTC derivatives markets done in 2016.

The market trades nonstop 24 a day, 5 days in a week — starting from the Sydney and Tokyo markets to London and New York markets and back to the Sydney market. 

In this post, we will discuss what forex trading is, the participants in the market, and how the market works. 

What is forex trading?

Simply put, forex trading is the means of converting one currency into another for any of the many different reasons —traveling and tourism, commerce, hedging against exchange and interest rate risks, and, of course, speculation. 

Take, for instance, some German citizens want to go on vacation to the US, they will need to exchange their euros (EUR) to U.S.

dollars (USD) at a bank or in an exchange house to be able to buy foods and pay for accommodation in the US. 

Similarly, if a British company wants to open a branch in Australia, the company will have to exchange their Great British Pounds (GBP) to the Australian dollars (AUD) to be able to transact in the Australian market.

For hedging purposes, an importer in Nigeria many decide to convert his business funds to USD or EUR for fear of naira depreciation.

In this case, he changes his local naira to the currency of choice even when he is not ordering any goods at that moment.

He would rather prefer to keep the funds in foreign currency until he needs it.

Apart from all these practical reasons for trading the forex market, the great majority of foreign exchange trading comes from speculation — which is trading with the hope of making a profit, while accepting the risk of a loss.

Traders buy a currency and hope that it will increase in value or sell and hope that it will depreciate.

The amount of volatility in the forex market makes it possible for the price of a currency to appreciate or depreciate significantly. 

The forex market is a digital marketplace where institutions like commercial banks, central banks, money managers, and corporations, as well as individual traders, exchange one currency for another. 

Unlike the stocks and commodity market, which are Exchange-based, the forex market is an Over-the-Counter (OTC) market, where liquidity is provided electronically by a network of banks in different parts of the world.

So, it can be called an interbank market, and trading can go on continuously 24 hours per day on all business days, as long as there are banks in Sydney, Tokyo, Frankfurt, London, or New York open for business.

The spot forex market is open from 5 pm EST on Sunday, to 5 pm EST on Friday. On every trading day, the market starts with the Australian/Asian session, which opens by 5 pm EST.

Before the Asian session closes by 4 am EST, the London/Frankfurt session has already opened by 3 am EST and stays on till 11 am EST, but before then, the New York session has opened by 8 am EST.

By the time the New York session closes by 5 pm EST to round off the 24-hour period, the next Australian/Asian session has opened.

Thus, there is no central location; the market is spread in different parts of the world and can be traded from anywhere in the world once you are connected to the internet. 

How currencies are quoted in forex

In forex trading, you are either purchasing one currency with another currency or selling one to buy the other.

Thus, currencies are quoted in pairs. For example, you can have EUR/USD, GBP/JPY, and so on.

The currency symbol before the “/” is called the base currency, and the one after it is called the counter currency or the quote currency.

In the EUR/USD pair, the EUR is the base currency, while the USD is called the quote or counter currency.

When you are buying this currency pair, you are actually paying with the USD to buy the EUR. Selling this pair means paying with the EUR to buy the USD.

A currency pair is usually quoted with two prices as follows:

EUR/USD: 1.08372   1.08361

Where the first price, 1.08372, is known as the Ask price, while the second one, 1.08361, is called the Bid price.

You buy at the Ask price and sell at the bid price. The difference between the two quoted prices is called the spread, which is usually the cost of trading the currency pair. In this case, it is 1.1 pips (1.08372 – 1.08361).

What do those numbers mean? It means that if you are buying the currency pay, you would need to pay 1.08372 for one unit of EUR, and if you are selling the currency pair, you would get 1.08361 USD for one unit of EUR sold.

As a speculative trader, you buy the currency pair if your analysis shows that the EUR will increase in value relative to the USD, and you sell the pair if your analysis shows that the EUR will depreciate relative to the USD (the USD will gain in value).

Categories of currency pairs

The currency pairs are grouped into three categories — major pairs, minor pairs, and exotic pairs — depending on how frequently they are traded:

Major pairs

These include the seven currencies that are mostly traded in the forex market. In fact, they make up over 80% of the total currency trading worldwide, and, together, they form six currency pairs: EUR/USD, USD/JPY, GBP/USD, USD/CAD, AUD/USD, and USD/CHF.

Minor pairs

These are less frequently traded. They are usually formed by pairing the major currencies against each other, rather than the USD. The EUR/GBP, EUR/CHF, and GBP/JPY are some of the examples.

Exotic pairs

These are very rare currency pairs, and they are less liquid than the others. They are formed by pairing a major currency with one from the emerging economies.

Examples are USD/ZAR (USD vs. South African Rand), USD/PLN (USD vs. Polish zloty), and GBP/MXN (Sterling vs. Mexican peso).

History of the forex trading

While people have been exchanging one currency for another for business purposes since nations started trading with currencies, the forex trading that you participate in now is relatively a new invention that came with the Bretton Woods accord in 1971 — major economies like the US, UK, Japan, Britain, Australia, Canada, and European countries allowed their currencies to float freely.

As a result, the values of the currencies appreciate or depreciate relative to one another, creating opportunities for speculative trading.

However, before the advent of the internet, forex trading was not readily accessible to individual investors or what we call retail traders.

At that time, most forex traders were the big banks, hedge funds, multinational corporations, and high-net-worth individuals since huge capital was required to trade forex. 

But with the availability of the internet and personal computers, low-budget individuals can easily set up and gain access to the forex market.

Hence, there was a proliferation of online brokers that offer forex trading to retail traders. And, some banks even started offering online forex trading to individual traders.

Since retail traders tend to have small trading capital, the banks and online brokers offer them sizeable leverage so that they can control a significant trade with a small account balance.

Participants in the forex market

The main participants in the forex market include:

  • The central banks
  • The commercial banks
  • Other financial institutions like the hedge funds
  • Corporations
  • The brokers
  • Your fellow retail traders

These are the people you battle with when trading the forex market, so you must be on top of your game if you want to get anything out of the battle. Let’s take a look at them one by one.

The central banks

The central banks are at the center of everything about the forex market. They are the ones that make the policies that affect the value of currencies. 


For instance, if a country’s central bank increases their interest rate, the country’s currency will appreciate in value, but if they reduce the interest rate or inject more money into their economy (quantitative easing), the currency will depreciate.

In essence, a central bank is indirectly in control of the supply of their currency. That is why central bank meetings and reports usually bring a lot of volatility in the market.

The U.S. Federal Reserve Bank and the European Central Bank have the most effect on the forex market because many forex pairs have either of them.

Other major central banks include the Bank of Japan, Bank of England, Bank of Canada, and the Reserve Bank of Australia.

The commercial banks

The big commercial banks across the globe, such as Goldman Sachs, HSBC, Barclays, Deutsche Bank, and others are often at the other end of most trades in the forex market, so they provide liquidity in the market.

Apart from trading for profit, they are also trading the market to hedge their book against market risks.

These guys can make huge others that move the market, which is why they are called smart money — they mostly decide where the market is headed.

When trading the market, your aim should be to identify where the smart money is headed and follow their lead.

Other financial institutions 

Other non-banking financial institutions are also major players in the forex market. Examples of such institutions include hedge funds and investment funds like pension funds and insurance companies.

They trade forex either to diversify their portfolio or to hedge their investments against exchange and interest rate risks.

These institutions also trade huge orders that can cause significant price movements, so they are also considered part of the smart money. 

Corporations

Most corporations depend on the forex market for their abroad business operations. For example, an American electric car marker may want to get some car parts from China and will have to exchange their U.S. dollars for the Chinese yuan to be able to pay the manufacturer in china.  

Corporations have these types of needs on a daily basis, so most of the time, they work closely with the commercial banks to get the forex they need for their international engagements.  

The brokers

Your broker is the one that takes your trade orders and sends them to the liquidity providers, so they play a big part in your battle to stay alive in the market.

There are different types of brokers: market makers, STP brokers, and ECN brokers. 

STP brokers act like agents; they take your orders and wire them straight to the liquidity providers (the banks), while ECN brokers offer traders direct market access (DMA) to the liquidity providers.

Market makers absorb all the orders they get first and only channel the excess to the liquidity providers.

In other words, if your broker is a market maker, they may be trading against you, and conflict of interest can be a major issue.

Retail traders

The other group of participants in the forex market is your fellow retail traders.

These are unlikely to have significant effects on price movements, except during the periods with extremely low liquidity — for example, when there is a bank holiday in a major market like New York.

How does forex trading work?

Despite what some people may want you to believe, forex trading is a pretty tough job. At the basic level, forex trading involves clicking the right button — buy or sell — and your broker filling your order with the liquidity provider.

Then, the market moves in your favor, and you exit your trade with a profit. Easy right? Well, it is not that simple.

You need to know when to click the buy button and when to click the sell button, and that, my friend, is damn difficult.

Forex trading requires you not only to understand how the system works but also to prepare for every situation in the market.

As we said before, it is a battle, and it’s the type of battle where fortune favors the prepared. A good way to approach forex trading is to follow the steps below:

1. Get prepared

To trade the forex market effectively, you need to learn a lot of things about forex trading — how to do fundamental analysis, how to do technical analysis, how to formulate a trading strategy that suits your trading style, and how to control your emotions when trading.

Some of the ways to improve your forex trading readiness are through books, enrolling in a trading course, and self-practicing with a demo account.

Whatever learning route you want to follow, here are some basic things you must learn about forex trading before even opening a demo account:

-Pip: A pip is a unit for measuring the price movement of a currency pair and is usually determined by a unit displacement in the fourth decimal place of a currency pair quote that has five decimal places or the third decimal place for a quote with only three decimal places (USD/JPY).

For instance, if the Ask price of EUR/USD moves from 1.08372 to 1.08382, then the price has made 1.0 pip movement. The fifth decimal place in the quote stands for the pipette, which is one-tenth of the pip. 

-Spread: It is the difference between the Ask price and Bid price. Brokers that don’t charge commissions often mark up their spread to accommodate the commission charges. 

-Lot size: In forex trading, the volume of a trade is graded in lots, mini-lots, and micro-lots. A lot represents 100,000 units of the base currency; a mini-lot is 10,000 units of the base currency, while a micro-lot is 1,000 units of the base currency.

-Leverage: This is the ability to control a large volume of trade with a smaller trading account balance.

If you use a 10,000 USD account balance to carry a full lot of USD/CHF, your leverage is x10. Similarly, if you used a 1,000 USD account balance to carry a full lot, your leverage is x100. While using leverage can multiply your profits, it can also multiply your losses.

-Margin: A margin is the minimum account balance required to open and maintain a leveraged trade. It is often expressed as a percentage of the full position.

-Factors that move the forex market: Many factors can move the forex market. Some of them include central bank policies, political news, economic data, and credit ratings of countries.

2. Find the right broker

You need a good broker if you will ever make it in your trading career. Some are dishonest and will take the opposite end of your trade, which often comes with a conflict of interest.

Be sure the broker you want to register with is regulated by a tier-1 financial regulator like the FCA, CFTC, and ASIC. Here’s one thing you should know; most offshore-based brokers are not well regulated.

3. Developing your trading strategy and plan

Take your time to develop a suitable trading strategy and plan. The only way to do this is by trading the market in a risk-free environment, using a demo account.

With a demo account, you can back-test and forward-test your strategy to be sure it has a positive expectancy.

4. Opening a live account with a trusted broker

When you are sure that your strategy is good enough to be tried on a live account, you can open a live account with a well-regulated broker and deposit one-fifth of your intended trading capital just to test the waters and also train your trading mind. When everything is looking good, you can trade with the full capital.

The benefits of trading forex

There are many benefits that come with forex trading, which makes it appealing to new investors, and these are some of them:

-Round-the-clock market: The fact that the market is open 24/5 means that you can trade at any time you want. So, if you’re busy during the day with your job, you can trade at night. 

-Huge liquidity: The forex market has the largest daily trading volume, so there’s enough liquidity in the market, making it easy to enter or exit the market. 

-Ease of trading in either direction: Unlike stock trading that has strict requirements for taking a short position, with forex trading, you can easily trade in either direction.

-Small initial investment: Of all the financial markets, forex is the cheapest to invest in. Some brokers require as low as $10 for the initial deposit.

Forex trading challenges

Despite the benefits, there are some challenges as well, especially when you’re just starting out:

-A steep learning curve: There is a whole lot to learn before you can profitably trade the forex market.

Apart from learning fundamental and technical analysis, you also need to develop the right trading mindset or face the risk of trading emotionally, which can decimate your trading account.

-Managing leverage: While the high leverage in forex trading may seem like a good thing, using excessive leverage is one of the reasons new traders blow their accounts in no time.

-Unregulated brokers: There are many poorly regulated and dishonest brokers on the internet, and funny enough, they are the ones that do the most adverts. So, it’s easy to fall into their hands.

Final words

Forex trading means exchanging one currency for another. It can be done for any reason, but retail investors only trade to make a profit from price movements.

With its enormous liquidity, forex trading presents an almost limitless opportunity for making money if you know what you’re doing. 

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