Understanding Forex Trading


What Is Forex Trading?

Foreign Exchange Trading is the exercise of exchanging one foreign currency for another. Forex trade always involves two currencies, where you sell one currency and at the same time buy up the other. For example, you can trade the US Dollar for the Japanese Yen— this involves selling the US dollar in exchange for the Japanese Yen. The pair of currencies is the US Dollar and the Japanese Yen.

If you ever go to a foreign currency exchange website, you will see currency listed in the form of three alphabets. This is the normal practice across all currency exchange markets—if we follow the previous example, the US Dollar is listed as USD and the Japanese Yen is listed as JPY. These listings are often written like JPY/USD, which means that you’re buying the Japanese Yen in exchange for the US Dollar.

You should know that you can virtually buy any currency in exchange for another and each currency is always listed in the form of three alphabets.

In case you’re considering entering the foreign exchange market, it makes sense that you should understand the special terms people use to refer to certain types of exchanges. First things first, there are four types of currency pairs that people exchange, these include:

Major Pairs: These are currency pairs that have the highest trade volumes, incidentally these trades also involve major currencies traded against the US Dollar.

The eight major currencies in the world, with the following pairings:

  • Euro/US Dollar (EUR/USD)
  • US Dollar/Japanese Yen (USD/JPY)
  • Great Britain Pound/US Dollar (GBP/USD)
  • Australian Dollar/US Dollar (AUD/USD)
  • US Dollar/Swiss Franc (USD/CHF)
  • New Zealand Dollar/US Dollar (NZD/USD)
  • US Dollar/Canadian Dollar (USD/CAD)

Minor Pairs: As a rule of thumb, any major currency trade pair that does not involve the US Dollar is a minor pair trade. So, if you’re trading the Euro, Yen, Pound Sterling, Australian Dollar, Swiss Franc, New Zealand Dollar or the Canadian Dollar with each other— you’re trading a minor pair.

Exotic Pair: These trades involve pairs of major currencies with those from “emerging markets”. Emerging markets are those that have achieved significant economic growth and are on the path to becoming fully developed. There are ten recognized emerging markets in the world:

  • Argentina
  • Brazil
  • China
  • India
  • Indonesia
  • Mexico
  • Poland
  • South Africa
  • South Korea
  • Turkey

If you’re trading a major currency with the currency from these ten countries, then you’re trading an exotic pair.

Regional Pairs: These are currency pairs for countries within the same region. So if you’re trading the Euro for the Swiss Franc (CHF/EUR)—this is a regional pair because both currencies belong to countries that lie in the same region.


How Does Forex Trading Work?

Forex trading isn’t a very complicated exercise, if you’ve ever exchanged currency at a bank—you’ve traded forex as well. Most people trade foreign exchange to fund their business activities in different countries—but a lot of people trade to make profits through their trades as well.

Before going into an explanation of how people make profits through their foreign exchange trades, you should know that Forex trading is quite different from stock trading in some basic ways. For one thing, there is no intermediary when you’re going to purchase or trade currency like the stock market. You can go to a bank or any money exchange service provider who will sell you the currency that you want to buy at the existing exchange rates in the market.

It’s interesting to note that most of these forex trades are made in the four financial centers of the world—London, Tokyo, Sydney and New York. However, there is no time limit on when the markets shutdown, so you can buy currency twenty-four hours a day.

Profiting in the Forex Market

People who go into the forex market for profits are also called speculators. We call them speculators because they base their currency purchase decisions on predictions of what a currency will be worth. A very basic example of this is as follows—let’s say you predict that the Japanese Yen will become expensive relative to the US Dollar in six months’ time. If the exchange rate is 1USD:1JPY, you predict that six months later the rate will rise to 3USD:1JPY.

You start buying the JPY based on this speculation that it will rise compared to the USD—if your speculations are correct, then you’ll have made a lot of money because the Yen will be worth more in terms of the US dollar. This is the simplest ways someone can make money on Forex—but most people make money off Forex trading through the following channels:

Spot Forex Markets: These are places where physical exchange of currencies takes place. If you’re trading currency at a bank—you’ve conducted an exchange “on the spot”. The example given before is most likely conducted in a spot forex market.

Forward Forex Markets: The trading parties decide an exchange rate and the amount of currency to be exchanged beforehand, signing a contract where they agree to make the exchange some specified date in the future. Usually these pre-decided exchange rates and trade volumes are non-negotiable. It is important to note that forward Forex Markets are privately negotiated.

Futures Forex Market: A special type of forward forex trading market, that is not privately negotiable—but instead are traded on standardized exchanges.

How are Currencies Priced?

In a normal currency pair like EUR/USD, the EUR is called base currency and USD is called the quote currency. In any pair the first currency listed is the base and the second currency listed is the quote currency. There is a number attached to this pair that tells you how much of the base currency you can get for one unit of the quote currency.

So, if you see that the EUR/USD is trading at $3, this means that one Euro is worth three dollars. If the price of the pair rises then EUR gets more expensive compared to the USD and if the price of the pair falls, then the EUR has become less valuable relative to the USD. Based on these price changes you can choose to buy or sell the currency.

Understanding Leverage in Forex

All currency traders are required to open an account with a broker and maintain a minimum deposit in their accounts. This is called a leveraged position, where you maintain this minimum deposit—in return for which the trade loans you the funds to make trades worth higher than amount you deposit. Most brokers offer leverage rates of 100:1, 50:1 and 200:1 depending on how large the transaction is.

These leveraged positions can help you make a lot of money, for example—with a 100:1 leverage ratio, you can make investments of $100,000 with a deposit of $1000. If you make a profit on this, your earnings relative to the initial investment is huge. However, if you make loss on these returns—you’ll have to make it up to your broker who loaned you the rest of the $99,000 to trade.

Understanding Margins

Margins are used to refer to the initial deposit you made with your broker. The leverage ratios offered by your broker, when expressed as a percentage is also called the margin rates. These are offered at rates of 1%, 2% and 0.5%.


Measuring Movements in the Forex Market

We measure currency movements in “pips” this is number in the fourth decimal place in the price of a currency pair. So, if the price of the pair EUR/USD goes from $1.234567 to $1.234667, we say that the price of the pair has increased by a single pip. All the numbers that come after the pip are called micro-pips or pipettes.

If currencies are listed in different denominations, then the position of the pip changes—for example, when you consider the pair EUR/JPY. The second decimal in the pair EUR/JPY is the pip.

What is Spread?

The spread is the difference between the buy and sell prices of any forex pair. So if you bought the pair JPY/USD at $1.2345 and sold it at $1.2346, then the spread is 1 pip.

As a general rule, if you’re looking to buy a currency pair then you offer a price that’s higher than the market price—to convince pair holders to sell to you at a profit. If you’re looking to sell a pair, you’ll need to offer a price below the market price to convince people to buy the pair from you.

Appreciating the Trade Volumes in Forex

While understanding Forex trading is quite easy, things get a little complicated when you start thinking of making a lot of money in these markets. Since the changes in currency pairs are usually quite small, you need to increase the trade size to achieve significant gains. An increase of 4 pips isn’t a lot of profit—unless you’re trading millions in currency the base currency.

In the market we term a standard trade lot as a trade involving 100,000 currency units. Mini lots include trade for 10,000 units and micro-lots include trade for 1000 currency units. Your broker will present you multiple trade options for you to pick out with different leverages.


Determining the Price of Forex

Before you take on the market and start speculating, you’ll need to understand how the market sets currency values. Like any other commodity, the price of foreign currency is determined by supply and demand. Usually, economies that are doing well have high valued currencies and those that aren’t doing well have low valued currencies.

Currency Supply Determinants

Central banks are the basic sources of foreign currency. Since these institutions print and inject currency into the market, they decide the supply of their local currencies in the market. Sometimes other stakeholders might get a hold on a large amount of currencies to affect the supply in the market also.

Besides printing currency, central banks also set interest rates that can force economic currents in a way to change currency prices. Higher interest rates, for example, increase the demand for a currency and restrict its supply as people buy more of the currency to earn from the high interest.

Currency Demand Determinants

Currency demand depends on how the economy is doing and what the reports in the market sound like. If the US hits a recession, the speculators will start dumping dollars into Forex markets—increasing supply and decreasing the demand for the currency. As a result the USD will depreciate compared to other currencies its paired with. We can assess economy conditions by looking at:

  • Employment rates
  • Production forecast
  • Inflation rates
  • GDP growth rates
  • Total sales revenues

Understanding the Market Sentiment

Sometimes, the entire market is convinced that a currency will strengthen or weaken to sell/buy the currency depending on the consensus. These massive movements across the entire markets can also affect currency pricing.

Forex *Reference: https://www.ig.com/