How does Forex work?
Novice forex traders often have trouble understanding how forex trading works, and what the foreign exchange market is.
This article explains in detail:
- What is forex?
- Basic forex trading terms
- How does forex work?
- Who trades currency pairs?
- What is forex trading?
- How to trade the forex market?
- Why trading forex?
What is forex? Definition and explication
The forex market (also known as the foreign exchange market) is where currency pairs like EURUSD or GBPUSD are exchanged. Forex is an over the counter (OTC) market; investors and traders buy and sell currency pairs.
Currencies, contrarily to most other tradable financial assets, are economic instruments as much as they are economic indicators. In other words, if countries were companies currencies would be their shares.
The forex market is the most liquid (as it also is the most accessible one). Therefore, it is the hardest market to manipulate.
Basic forex trading terms
Knowing the vocabulary used by investors and forex brokers won't make you an excellent trader, but it is essential to know it in order to become one.
Here are some of the most important forex trading terms:
- Currency pairs
- Lot / contract / position size
- Trading platforms
Any investor who wants to start trading on the forex market needs to understand how this market works, and also needs to know the basic terms which are used regarding this particular market. Starting with a demonstration account is a good way to learn and understand the forex market.
Forex quotes – Explication
Understanding how currency pairs work is essential before going any further. For example, let's take the EUR/USD currency pair. The euro is called the base currency (or the transaction currency) and the US dollar the counter currency. The power balance between the base currency and the counter currency gives us the forex quote.
When looking at EURUSD or other currency pairs on a trading platform, we can see two quotes: the bid price and the ask price. It is usually displayed like this: EURUSD 1.1238/1.1240. The ask price indicates to us that we can buy 1 € with 1.1240 $.
In parallel, the bid price indicates to us that we can sell 1 € for 1.1238 $. It is quite easy to remember that banks usually sell currencies higher than what they acquired it for. They are able to do that as they have more influence than brokers.
You can't just buy or sell EURUSD, as you would do with company shares for example. The EURUSD currency pair doesn't really exist. To better explain this concept, you can't buy any goods with EURUSD; it's not a currency. Currencies are worth something on their own, not as pairs. Therefore, traders trade the strength of currencies in relation to others, by buying and selling currency pairs.
On the forex market, profits are made through the appreciation or the depreciation of a currency in relation to another. Let's say you're buying euros and selling US dollars (through the EURUSD pair). In order to make a profit from this trade, you will have to wait for the euro to appreciate against the US dollar.
Which currencies are traded on the forex market?
For this forex article to be really complete, we need to review the most popular assets traders have access to.
The most traded currencies are the euro (EUR), the US dollar (USD), the Japanese yen (JPY), this British pound (GBP) and the Swiss Franc (CHF). Therefore, the most popular currency pairs (also known as majors) are the ones involving the most exchanged currencies: EURUSD, GBPUSD, USDJPY or USDCHF.
Three other currencies are very frequent in forex trading: the New Zealand dollar (NZD), the Australian Dollar (AUD) and the Canadian dollar (CAD). When associated with other currencies in a pair, they are categorized as "minors": NZDCAD, USDCAD or AUDUSD.
All currency pairs involving the Russian rouble, the Czech koruna, the Polish zloty, the Hungarian forint, the Swedish Krone or the Norwegian Krona are considered as "exotic" pairs. They only represent 10% of all currency exchanges.
Who trades on the forex market?
The most important forex operators are:
- Central banks
- Private banks
- Hedge funds
- Investment funds
- Retail and professional traders/investors
Among all market operators, central banks have the most influence on forex quotes. Indeed, their policies (quantitative easing) and decisions (interest rates) regulate the "supply" of the currency they are in charge of.
Retail traders and investors only have a limited impact on the market, but not negligible due to the amount there are.
To understand the forex market, one must know that currencies supply and demand are in perpetual evolution. This price evolution can be followed by traders on trading platforms through candlestick, bar, or tick charts.
Understanding the exchange market
When it comes to the economy, supply and demand drive market prices. This principle is also true for the foreign exchange market.
When a currency is bought, the demand increases which pulls the price up. Likewise, each time a currency is sold the supply raises, pulling the price down. The impact of each buy and sell operation on the forex market is directly proportional to the position size (or volume) of each operation.
Most economic news and events that happen around the world have an impact on the markets. Therefore, understanding what the price is driven by is a key to become a good forex trader.
Factors influencing the forex market
The forex market and therefore currency pair quotes are impacted by several factors:
- Interest rates
- Inflation rates
- Politic and economic news
- Natural disasters
- The Gross Domestic Product (GDP)
- Supply and demand regarding the underlying instrument
The online forex broker industry – Explication
A constantly changing ocean is a good metaphor to illustrate the forex market. This ocean is inhabited with many fish. Some are big, and some others are small in relation to their impact on the market.
Big fish like banks, multinationals or hedge funds are major market actors. Average fish like private investors and mid-sized companies may use the forex market, in order to protect themselves against random fluctuations of their base currency. Finally, small fish are online brokers, small banks or retail traders and investors.
Most of the market operators mentioned above have access to the interbank forex market. This means that they can exchange currencies with each other without intermediaries.
The smallest player, the financial ocean's plankton – floating around, trying to survive long enough to grow up – is the retail forex trader.
The purchase power of retail traders is insignificant compared to big fish. Therefore, they need forex brokers or banks in order to get leverage and access to the market (through a trading platform). Retail traders can't get access to the forex market without an online forex broker.
What is forex trading?
Forex trading is a way to invest through buying or selling currency pairs. It is accessible for anyone who has a computer and an internet connection.
The word "trading" is quite simple to understand. It is an exchange of financial instruments between two market operators.
The goal of these trading operations usually is to make a profit through speculation, but can also be to hedge risks.
How to analyze the forex market?
Analysis isn't the only success key when it comes to trading; it is, in a way, trading itself. Being able to make good analysis is essential to becoming profitable on the forex market.
There are two main methods to analyze the market: fundamental analysis, and technical analysis.
The first one can be assimilated to the financial audit of a state, a country or the whole world. It is the oldest form of analysis and takes into consideration many elements like the current economic situation, the forecasted one, or the political climate.
GDP, unemployment rates, inflation, trade balances, retail sales, elections, natural disasters or wars are factors that can be looked into when making a fundamental analysis. It requires a good understanding and knowledge of the global economy, as it deals with factors which may not have been taken into account by the markets yet. Most long-term investors use fundamental analysis to make decisions.
The bad side of this analysis method is the incertitude generated due to the high number of important parameters.
On the other hand, technical analysis is the most recent analysis method. It is based on two factors: time and price. Both are quantifiable and measurable. This is the reason why many forex traders prefer technical analysis rather than fundamental analysis.
When you use supports and resistances, identify key areas or look at indicators or candlesticks, you don't get information about what's causing the supply and demand to change.
To make it easier, fundamental analysis relies on economic factors and predictions related to them, whereas technical analysis is based on what happened in the past and market cycles combined with statistics.
Profits are for informed people
The lack of formation is the reason why so many novice forex traders fail before understanding how forex trading works.
Some people present forex as a pseudo-scientific money game which comes to basically flip a coin. A fun and prestigious game, with the possibility to quickly generate high profits.
Obviously, when people without any formation start trading with this idea in mind, they are expecting to make a fortune from a very small investment. Full of hope, they jump into the market without any understanding of what they are doing. This usually results in losses. It is neither good nor bad, it is just the way the markets work. Each time you make a profit, someone else has to take a loss.
How to trade the forex market?
Forex trading is quite logic. A trader is going to buy or sell a currency pair if he is expecting the exchange rate to increase, or decrease.
For example, let's say the EURUSD exchange rate is 1.1450. The trader's analysis makes him think the exchange rate will go up. He opens a buy position. The next day, the EURUSD exchange rate is 1.1470 and the trader closes the position with a 20 pips profit. The profit could be 0,50$ as it could be 50 000$, depending on the position size.
When looking in detail how the forex market works, we realize that it's more than just placing orders on a chart.
A CFD (Contract For Difference) is a type of derivative traded by many investors. It provides all the benefits and risks of an underlying instrument without owning it. It also allows investors to trade bullish and bearish markets (thanks to short sell orders).
After choosing a forex broker and a trading account, traders need to install a trading platform and make a deposit.
Once traders have identified a market configuration or a key area on a currency pair like EURUSD, they will have to place an order.
It is highly advised not to rush when it comes to investment (even if it might be suitable for some forex trading approaches).
Fundamental or technical analysis is essential to invest online. Before opening a trade, we can start by analyzing market conditions, the appropriate money management, the trade length (in time), the market's volatility and economic news. Then, it is crucial to define a stop loss and a take profit. Only then, a trade can be opened.
Once again, good analysis is a key to success in online trading. It can be compared to a business plan for an entrepreneur seeking to start a professional activity. Being able to analyze and synthesize information is also essential to success in forex trading.
Finally, opening an order is the easiest part. We just need to fill the stop-loss and take profit values (the entry point as well if working with pending orders) and click on buy or sell through the trading platform.
Forex trading advantages
You are in charge. You decide where you want to be, when you want to work, and how much you want to work. Unemployment isn't scary anymore. When someone asks for your job, you can answer: I buy and I sell money.
Crises aren't a threat to you anymore. Why? Because during financial crises, most financial instruments follow the same trend. While most people prefer bullish trends, forex traders don't care about it; they can make profits whatever the direction of the trend is.
The 2008 crisis is a very good example. Real estate was depreciating, some currencies were losing a lot of their value and at the same time, oil was reaching new historic highs.
If you are an online trader, you probably know the three golden rules when it comes to trading in times of crisis: sell currencies, keep your real estate assets and buy oil.
Remember, speculation is a freedom offered by the capitalist world. CFD trading allows traders to benefit from crisis and wars, when they know what they are actually doing.
Why invest on the forex market?
- It is almost always open, 24 hours a day, 5 days a week
- It is the most liquid market
- Brokerage fees are low compared to other markets
- We can trade from wherever we are, we just need a computer, an internet connection and a broker
If this article is the first you're reading in order to learn the basics of forex, you shouldn't stop here. It was just a broad introduction as many topics need to be researched.
To better understand how the forex market works, we advise you to open a demonstration trading account.