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How does Forex trading work?

How does Forex trading work?

There are many aspiring traders at the start of their trading careers who barely understand how Forex trading works or if Forex trading works at all. The problem here is not about the Forex market, it's about their wrong approach. Those who attempt jump-starting a trading career and very soon leave defeated and broke, experience this due to other reasons than the market itself: wrong motives, improbable goals, greed, improper urgency, as well as lack of efforts and knowledge.

Thus, before acting in the Forex, take your time to think of how Forex works and how much hides behind the currency market. Pose the following questions to yourself:

  • Do I know how the price for any asset in the world is being formed?
  • Am I aware of the fundamental structure of the trading industry?
  • How are international economic interactions conducted?
  • Am I familiar with the key principles of fundamental and technical schools of market analysis?
  • Are there any psychological implications of being a trader?
  • What happens after I press the trader's button?

So, let's begin.

Basics: supply and demand

The science of economics uses the concepts of supply and demand to explain how the price is formed in a free competitive marketplace. A point in which quantity demanded by consumer equals that supplied by producer defines the price of goods.

Let us explain this with a grocery shopping example.

If you need some apples and there is only one seller with the right amount of them, you two will probably easily agree on the price and conduct the trade. You give away a certain amount of money for a certain number of apples. Great! You and the vendor have both got what you wanted. Next day, we presume, you want to buy the same quantity of apples – and now there are two sellers, each having the amount you need.

Now, the supply of apples is higher than there is demand for them. As the two vendors compete for you as a customer, they will decrease the price of apples assuming that you would probably choose the cheaper ones, given that all other conditions are equal. After the new price is set, you will choose one of the two sellers that you like more, thanking the free market forces for making the apples more affordable.

There is an opposite scenario.

If you came there with a friend who also wanted some apples but only one seller was available, the demand for the apples would be higher than supply. The seller would realize this and increase the price of his apples, being sure that you and your friend will certainly buy all of his apples and need even more.

This apple story is the ABC of economics. If you are an aspiring trader, make sure you understand the simple logic of this little apple market. When you do, you will also be able to understand how the Forex markets work.

As we continue our explanation, this will gradually get more and more complicated.

This apple-market logic is easily applicable to the Foreign exchange market. When certain currency is bought by a trader, the market sees a surplus demand for it. This sets the currency price higher. To the opposite, selling certain currency creates a surplus supply, which again throws the price off balance and sets it lower.

The degree of impact depends directly on a deal's trading volume: big players like national banks can cause high fluctuation by interfering with supplies of their country's currency. Smaller players – retail traders – have only the modest impact over the market, but still they have it even with their sheer numbers.

Such ever-changing supply and demand of currencies are the pulse of the Foreign exchange. In order to understand how online Forex trading works, you have to grasp the philosophy of price balancing. All economic developments of the world only matter for the market to the extent to which they affect the supply and demand of an asset. Or should we say the projected supply and demand, for this detail is important.

Going back to our apple market scenario, if one of the apple sellers went bankrupt this season, be prepared that the price of the apples will increase for both you and your friend before you even arrive to the market.

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Create a mental map of the industry to prevent you from getting lost

You can better understand how Forex market works if you think of it as an ever-changing ocean. The place is populated with different fish, from big to small, the size depending on their buying power. The largest are multi-billion leviathans – multinational corporations, hedge funds, national banks, and so on. They cause the largest waves and throw prices off balance the most with their monetary policy and trading decisions.

In the middle size segment, there are private banks, companies in need of hedging, private investors, etc. Smaller fish can also be found in the ocean – smaller investors, smaller banks, and financial brokers. The majority of the fish, aka market participants, can access the Forex Interbank directly – the place in the market where all the currency exchanging chemistry takes place. They have this access because they operate at certain level of funds amounts and higher, and it allows them trading with each other without any middlemen.

Of course, there is the plankton in the financial ocean. It's floating around, clinging to surviving and growth in the ocean in order to grow bigger. This is the retail Forex trader – you. Your buying power is, as a rule, so insignificant compared to that of the big fish that you cannot trade without a Forex broker or a bank. They are needed to secure you with a financially leveraged trading account and the real access to the market via their trading servers.

Now that you have an idea of how does Forex market work and can assess where your position in the scale of ocean fish is, you should feel the much-needed trading caution growing inside you.

How is this related to the powers that be?

As you should know by now, Forex is the currencies market. Unlike most other tradable assets, currencies are both economic tools and economic indicators. In other words, if countries were companies, currencies would have been their stock. The largest tweakers of money supply are policy makers at central banks, and their monetary policy decisions are the major price-affecting factor on Forex trading and how it works.

Interest rates set by the national bank of every country (where there is a national bank) are the most distinct example of such influence. As long as US Dollar, Euro, British Pound and Japanese Yen belong to the most traded currencies in the world, Federal Reserve Bank, European Central Bank, Bank of England and Bank of Japan can be considered the ocean's biggest fish.

As soon as you understand how this affects the economy, you will be able to understand how does the Forex market work?

Let's say a national bank has increased interest rates (it can easily do so solely on its decision) for its national currency. It will immediately become more expensive for the rest of the fish in the ocean to borrow that currency from that bank. This instantly provokes a shortage in currency supply, which in turn makes the price for it go higher. You might think it's a good thing, for every national bank wants its currency to be strong, right?

Well, not really.

In the short-term, this means less money to invest in business developments, lower expendable household income, and, eventually, slower rate of economic growth – not that exciting.

On the other hand, this makes inflation, as well as inevitable buildup of debt, slow down. In the long-term, this is very good.

The opposite scenario takes place when interest rates are cut. This makes all the fish in the ocean borrow more money. A surplus supply of money is created immediately, forcing the currency price down. In the short term, this will lead to expansion of business, more household spending, and a growth in economy.

And again, you might think this is good, but, again, not really. More borrowed money means more money owed. In the long term, the accumulated bank credit avalanches over everybody, causing a financial crisis. This is called the macro economic cycle.

This peak is natural for all economies of capitalistic type. The national banks' job is to permanently try and balance the scales by increasing and decreasing interest rates regularly. This is called the micro economic cycle. The economy cycles resemble those in climate change – they are quiet, unstoppable, and very hazardous for those fish that cannot see them approaching.

Forex trading, how does it work? Analysis is the essence

Analysis in not only the most essential thing for trading, it is trading to some degree. It's the only thing that does make Forex trading really work.

Market analysis comprises two major schools – Fundamental and Technical.

Fundamental analysis is a developed version of financial audit scaled to a country, or even the planet level. This is the oldest method of price estimation that takes a look into an economy: its current stage in the economy cycle, relevant events, future forecast, and the possible weighted influence over the market.

Fundamental analysis takes the following factors into account: a country's GDP and export amounts, unemployment and interest rates, economic advancements, elections, war, natural disasters, etc. It measures the impact in terms of influence on supply and demand.

For instance, new improvements in shale oil drilling technologies mean there might be a steady and increased supply of oil now and in coming years. This actually brought oil price down in winter 2014-15 to their decade low.

When using fundamental analysis, it's important to understand international economics, to be able to deal with factors as yet unaccounted for by the market; this will work for investing and long-term trading.

Of course, this large number of inputs can create the element of uncertainty, which is actually a drawback of this type of analysis. It also has a great advantage: when conducted correctly, fundamental analysis can predict fundamental price movements, which are good to know in order to generate profit over long term.

Technical analysis was developed later; this form of market analysis takes into account only two variables: the time and the price. These two parameters are accounted for by the market, can be measured, and are undeniable facts. This is why for many traders Forex trading works better with charts analysis than with economic examinations.

With technical analysis, you might create support and resistance lines, apply technical indicators, identify key levels or correlating candlestick formations – all of this is figuring out how online trading Forex works without analyzing supply and demand causes. Both short- and long-term trading can benefit from technical analysis. At the same time, this is the only method available for quick-style traders like scalpers, who gain from the well-known daily volatility of the Foreign exchange, not from trend following.

The power of the technical approach lies in its analysis of quantifiable information exactly as it has been recorded from the market – as data on the specific price at a specific time. The downside of it is that this data is from the past and has already affected the market. In order to trust the conclusions made by means of technical analysis, a trader must accept the idea that price formations from the past have an influence on price formations in the future. For many followers of the fundamental analysis this seems ridiculous.

If put simply, fundamental analysis looks into economy to make future prognosis, while technical analysis is based on visual price-time data combined with statistics.

Be prepared in order to be loved by fortune

Unfortunately, many beginner traders fail before they are even able to understand how does Forex trading work. This happens mostly due to lack of preparation.

There are many books written about the psychology of a trader, explaining how to prevent making mistakes that every trader is keen on making. Most of the solutions focus on the following: the problem lies in the approach, and it's easy to get lost when everything is unfamiliar.

There are brokers at Foreign exchange who believe Forex is some kind of quasi-scientific gambling that resembles coin flipping but with better methodology; the one that is more fun and more prestigious; the kind of gambling than offers chances to quickly gain significant profits.

Due to this approach, many beginner traders with poor or no training come to Forex with high expectations of making fortunes with their $10 in just a few decisive clicks of a mouse. They dive into the market ocean full of hopes, and it washes them ashore straight away, irritate and empty-pocketed. Most of the Forex traders face losses, and business models of their brokers are well adapted to it. This is neither good nor bad – it's just the way it is, and this is why market exists, after all. Whenever you gain at a trade, someone has to lose.

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How does Forex trading work in practice

Currency value is calculated with how much of another currency can be bought with it. This is called a price quote. The price quote comprises two prices – bid and ask. The ask price is used for buying a currency, and the bid is applied to selling.

The ask price of any financial instrument is always higher than the bid price. That's why a bank always buys your currency somewhat cheaper and sells it to you somewhat more expensive – it always has a bargaining high ground over a trader. The difference between bid and ask is called spread.

Market participants exchange bid and ask price information between them immediately at any time of the day, except when the market is not operating. A brokerage firm communicates quotes to its client traders who have account with it via the Internet. In its turn, the firm obtains price quotes from its providers of liquidity, the banks.

Fundamentally speaking, higher liquidity means tighter spread, and everybody benefits from it. As a rule, trading is uninterrupted and smooth, and liquidity is generous. However, when major news is released, prices may shift and create price gaps over the shortest spans of time.

The rest is just the mechanics of the Foreign exchange. Trades take place at simple clicks of mouse on the trading platform. Placing a buy order on EUR/USD, for instance, would mean that some funds from a trader's account are spent on buying the base currency of this pair, the Euro. The quoted currency, the US dollar, is sold. This is called 'placing a buy order,' and you might do it either within the broker (Market Maker) or directly with the Forex interbank market (ECN execution), where the big fish are. Please note that a trader can place an order that sells currency he does not 'own.'

Then, depending on a strategy a trader chose, he is watching the purchased currency as it grows in value relative to the sold one. At the moment when the gained profit is considered satisfactory by the trader, he closes the order. The broker then conducts the opposite set of transactions – he sells Euros and buys dollars. This was 'a buy order.' Placing 'a sell order' is a reverse process.

At first you might get confused with the concepts of buying and selling, for there is always a buy and a sell in each trade in Forex, as one currency is exchanged for another. If this is the case with you, it might help if you think of a currency pair as of an abstract financial instrument, which price is set by the market.

Now you have a better understanding of the market's structure in terms of its participants, major driving powers on the market, two main schools of market analysis, and how does online trading Forex work in practice.

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