What is Forex and how to trade on it?

09 Aug 2018

What is Forex and how to trade on it?

Forex, or just FX for short, stands for Foreign Exchange and refers to buying or selling one currency for another. This is the busiest financial market in the world, as companies, governments, and individuals alike take part in Forex trading. When you travel to another country and exchange your home currency to a local currency, you participate in the global currency market. The exchange rate between these two currencies will go up or down depending on the demand for both currencies.

Forex is a global decentralized market, where all currencies of the world are traded. This is by far the largest and the most liquid market, with an average daily turnover of over $5 trillion. Forex market players range from huge financial institutions managing billions of dollars to retail traders who enter the market with just a few hundred bucks.

Thanks to the web, you can now trade Forex pretty much the same way the large banks and investment funds do. To start, all you need is a computer with an Internet access, and a trading account with a Forex broker.

The purpose of foreign exchange is quite simple: like in case of any other speculative activity, you want to buy a currency at one price and sell it at a higher price, or sell a currency at one price and then buy it cheaper, in order to make profit.

How Forex Trading Works

In Forex, you basically exchange one currency for another. The most important thing here is the exchange rate between two currencies (a currency pair).

The currencies in Forex are always exchanged in a form of pairs. When you exchange US dollars for euros, there are two currencies involved. As such, in any currency transaction you exchange one currency for another. This is why Forex uses currency pairs, which show how much a currency costs with respect to another currency. EUR/USD pair, for instance, shows you how much US dollars (USD) you need to buy one euro (EUR).

In Forex, for each currency there is a symbol. The euro is known as EUR, and the US dollar, USD. Other popular symbols include: AUD for Australian dollar, GBP for British pound, CHF for Swiss franc, CAD for Canadian dollar, NZD for New Zealand dollar, and JPY for Japanese yen.

Each currency pair, such as EUR/USD, AUD/USD, or USD/JPY, has a market price. This price shows how much of the second currency you need to buy a single unit of the first one. As such, if EUR/USD price is 1.4500, this means you will need to pay 1.45 dollars per each euro you buy.

The first currency is always the one which determines the direction on a chart. If you look at the EUR/USD chart, with the price moving up, this will mean the EUR price is rising compared to USD. Conversely, if the chart is falling, this means EUR is going down compared to USD.

Here is a simplified example of a Forex transaction. Let's assume you decide to buy 1,000 euros for US dollars. The current EUR/USD price is 1.4500, and so you spend $1,450.

Later, you see the price has gone up to 1.5500, and you now want to sell euros for US dollars. You then sell your €1,000 and get $1,550 in exchange. So you started with $1,450 and now you have $1,550, which means you have earned $100. If, conversely, the price went down to 1.3500, you would sell your euros for $1,350, which, compared to your initial investment of $1,450, would mean $100 loss.

This is how you can earn or lose in Forex.

What Is Spread?

If you look at the quotes on your trading platform, you will see there are two prices for each currency pair. One of these is the price at which you can buy a currency, or the ask price, while the other one is the bid price, the one at which you can sell. The difference between these two prices is known as spread. The ask price is always higher than the bid price.

At the moment of buying a currency pair, the platform will always show the price at which you can buy the first currency against the second. As such, if the bid price for EUR/USD is 1.300, you will buy each euro at $1.30. If you think the EUR price will get higher compared to USD, i.e. you will be able to sell 1 euro for more than 1.30 dollars, you will be buying. Conversely, when you are selling, the platform will give you the price at which you can sell one currency against the other. As such, if the bid price for EUR/USD is 1.300, you will sell each euro at $1.30. You will be selling in case you think the EUR price is going to fall, allowing you to buy euros cheaper than you originally paid.

What Is a Pip?

A pip is the fourth decimal in a currency pair price, except for JPY pairs, where it's the second decimal. If the EUR/USD price moves from 1.3600 to 1.3650, it is a 50-pip movement; if you buy the pair at 1.3600 and sell it at 1.3650, you have earned a 50-pip profit.

The absolute gain you got from this hypothetical transaction depends on the amount of the bought currency. If you bought $1,000 (i.e. a micro lot), each pip is worth $0.10, so you get $5 for 50 pips. If you bought a mini lot, i.e. $10,000, your pip value is $1, and your gain is then $50. Finally, in case of a standard lot, i.e. $100.000, your pip value is $10, and your gain is $500. This is all valid in case your trading account base currency is US dollar.

The amount a single pip is worth is called the pip value. For each currency pair where USD is the second currency, the pip values are as mentioned above. In case USD is the first currency in a pair, the pip value may be slightly different. For instance, if you want to calculate your pip value for USD/CHF, what you actually need is divide your normal USD pip value (see above) by the USD/CHF current exchange rate. For example, micro lot pip value will be $0.10 / 0.9435 = $0.1060, where 0.9435 is the current pair price and is changeable. The same applies to JPY pairs, such as USD/JPY, but you need then to multiply the result by 100.

What Is Leverage?

Basically, leverage is a tool that allows you to open and manage a larger position with a smaller amount of money. Through this you can increase your profit margin by maximizing your trading funds potential. You need just a fraction of your total position value in order to open a transaction. The difference between the full contract value and the amount you deposit in order to open your position is actually your leverage ratio.

If your FX broker offers you a 20:1 leverage, this means you can trade positions 20 times larger than your trading account. As such, if you want to buy 20,000 EUR/USD units, you just need 1,000 euros to open your position. This leads to any potential profit or loss being 20 times larger, too, which means you have to be cautious and weight your risks before opening such a position.

What Is a CFD?

CFD stands for Contract for Difference, and trading CFD's is a certain form of speculation in the financial markets where you don't need to buy or sell any underlying assets. You can learn more about CFD's by clicking here.

What Does It Mean to Go Long or Short?

Taking a long position means buying a security expecting it to appreciate (rise). This is called long because it usually takes a longer period for the markets to go up than to fall. So, in essence, going long just means buying.

Taking a short position means selling a security expecting it to depreciate (fall). As a rule, the markers usually fall much faster and more abruptly than they rise, hence the name. Basically, going long means selling.

Conclusion and How to Start Trading

By understanding the concepts explained above you will be able to get what is happening when you see the currency pairs rising or falling on the chart. This will also help you see trading opportunities during such movements.

We hope you found this article helpful. Please don't hesitate to share your questions or ideas in the comments section.

To start trading, open a FREE DEMO ACCOUNT and log in. Then select a currency pair, e.g. EUR/USD, select your investment amount and buy if you expect the pair to rise. Thus, you will become a trader in the market used by millions of people throughout the world. You will earn if EUR/USD rises or lose if it falls.

We do recommend you checking out our free lessons before you start trading on a real account.

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