What is Forex Trading and How Does it Work ?

What is Forex Trading and How Does it WorkForex trading, also known as FX or Foreign exchange is one of the world’s most traded markets with a daily trading of over $5.3 trillion. The FX market allows traders to speculate on the price movement of international currency markets. Forex trading is not conducted at one central location, but is done between participants through ECNs (electronic communication networks) and phone networks from various markets across the globe. This market is open 24 hours a day, five days a week.

What is Forex trading ?

FX is the trading of currencies- buying or selling one against another. IT allows traders to speculate on the changes in currency strengths over time. Forex traders profit from the fluctuations in the exchange rate between currencies. With over $5 trillion being traded every day, the Forex trading market is very volatile- highly liquid and dynamic market. This means that the rates can change rapidly in response to short-term events and news, creating multiple trading opportunities for traders.

How Trading currencies work

Forex trading works just like any other financial market. In this market, traders can either buy or sell currencies at the current rate. The primary objective of this trade is to profit from your position. Forex is always cited in currency pairs. The difference in the exchange rate of the currency pairs is an important factor in currency trading. Here is an example of a currency pair and the exchange rate:

Currency Pair Current Exchange Rate
GBP/USD 1.7430
EUR/USD 1.5500

Exchange rates can change very fast, sometimes even several times within a second. Generally, the currency exchange rate reflects the health of a country’s economy. For instance, if the economy of Great Britain is doing better compared to the economy of the United States, the pound will go up as opposed to the dollar and vise-versa.

What is a currency pair?

Forex trading involves the buying and selling of one currency against another. It is for this reason that the currencies are quoted in pairs to show traders which one is being sold and which one is being bought. Each currency in a currency pair is denoted in a three letter code. The code is formed by two letters that represent the region and the currency itself. For instance, GBP/USD is a currency pair that involves the Great British Pound and the United States Dollar. In this particular pair, you are selling USD to buy GBP.

Base and Quote Currency
The first currency listed on a currency pair is the base currency, whereas the second is the quote currency. The price listed on a Forex pair represents how much one unit of the base currency is worth in the quote currency.

For instance, in the currency pair EUR/USD, EUR is the base, whereas USD is the quote currency. Now, if the currency pair EUR/USD is trading at 1.55361, it merely means that 1 euro is worth 1.55361 dollars.

If the euro rises against the dollar, the pair’s price will increase and vice versa. If you think the base currency is likely to strengthen, you should consider buying the pair, which is also known as going long. On the contrary, if you predict a weakening of the base price, you should sell the pair, which is also known as going short.

Spread
The price quotes on the forex trading platform come in two values for the currency pair. The first one is the buying price (ask price) while the second is the selling price (bid price). The Spread is the variance between the asking and the bidding price. Note that the asking price is always more than the bid price.

Leverage
Forex brokers offer their clients’ advantage to trade on a bigger level. For instance, if they offer you 1:100 leverage, this simply gives you the ability to trade with money that is 100 times more than your actual deposit. Hence, with just a deposit of 1000 pounds, you can buy 100,000 GBP/USD. The 1:100 leverage allows you to trade with 100 larger values than your actual deposit. This, in turn, equals profits or losses that are 100 times bigger. Hence, you need to be extremely cautious when placing your trades.

PIP
PIP is an acronym for “Percentage in Point.” In Forex trading, PIP is the minimum possible shift in the value of a currency pair. Currencies are prized in 4 decimals, except for the JPY (Japanese Yen), which uses 2 decimal places. A PIP is equivalent to one digit shift in the fourth decimal. For instance, if the EUR/USD pair moves from $1.55361 to $1.55371, then it has moved one PIP.

What affects currency prices ?

One of the biggest movers of currencies is supply and demand. When the world needs more dollars, then the value of dollars increases. However, if there are too many dollars in circulation, the price drops. Some of the other factors that move currencies include the interest rates, geopolitical tensions, new economic data from the most prominent countries just to name but a few.

How do traders make money on the Forex market? Here is an example of how people make money on the Forex market:

If you decide to trade 1,000 euros against dollars at an exchange rate of 1.5500, you will end up paying $1 550.Later on, the pair’s exchange rate that you sell your euros for US dollar can move to 1.6500. So if you decide to sell €1,000, you will get $1,650. Having started trading at just $1,550, you now have $1,650 which equals to $100 in profit. Again, the currency pair’s exchange rate that you sell your euros for US dollars can decrease to 1.4500. After selling your €1 000, you will get $1,450. So having started at $1,550, and sold at $1,450, you will have made a loss of $100. This is how money is made or lost on the Forex market.

When starting out in the Forex market, it is paramount for beginners to understand that this market can quickly take away your money, especially if you think that trading is easy. Forex trading, just like any other investment market is challenging, and success comes with time, learning, and constant practice. Most Forex brokers allow new users to open a free virtual account that allows you to trade with virtual money until you find unique strategies that work for you.

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