What is Forex Trading and How it Works?
By: Smith L Sutphin
Tags: Forex Trading, Forex Traders, Foreign Policy, Forex

What Is Forex Trading?

Forex trading is at its simplest, equivalent to the exchange of currencies that you would do when going abroad: a trader buys one currency and sells another and the exchange rate fluctuates continuously depending on supply and demand.

In the foreign exchange market, a global marketplace that is open 24 hours a day Monday through Friday, currencies are traded. All forex trade is carried out over the counter (OTC), which ensures that there is no physical exchange (as with stocks) and that the market is overseen by a global network of banks and other financial institutions (instead of a central exchange, such as the New York Stock Exchange).

A vast majority of trade activity in the forex market occurs between institutional traders, such as people who work for banks, fund managers and multinational corporations. These traders don’t necessarily intend to take physical possession of the currencies themselves; they may simply be speculating about or hedging against future exchange rate fluctuations.

For example, a forex trader might buy U.S. dollars (and sell euros) if she believes the dollar will strengthen in value and therefore be able to buy more euros in the future. Meanwhile, an American company with European operations could use the forex market as a hedge in the event the euro weakens, meaning the value of their income earned there falls.

Forex Trading Marketplace

The forex trading marketplace, as it stands today, is the world’s largest and most liquid market due to a number of factors which include, but are not limited to, ease of performing transactions over the internet, the modern development of travelling, ease of international communication and modern transportation, which have made our world a smaller place.

By making our world a smaller and more global place, this automatically means that people, goods and services can travel faster and more easily. This also means that a necessity of currencies to be traded against each other is needed in order for this to happen. All these factors have determined a growing forex trading marketplace, which will only continue to grow and become more dynamic, liquid and responsive.

How Currencies Are Traded

Just like a stock’s ticker symbol, all currencies are assigned a three-letter code. Although there are more than 170 currencies worldwide, a significant majority of forex trade includes the U.S. dollar, so it is particularly useful to know its code: USD. The euro, the currency recognized in 19 countries in the European Union (code: EUR), is the second most common currency in the forex market.

The Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF) and the New Zealand dollar (NZD) are the other main currencies, in order of popularity.

All forex trading is expressed as the two currencies being traded in a combination. The following seven currency pairs, known as the majors, account for approximately 75 percent of forex market trading:

EUR/USD

USD/JPY

GBP/USD

AUD/USD

USD/CAD

USD/CHF

NZD/USD

How Forex Trades Are Quoted

Each currency pair represents the current exchange rate for the two currencies. Here’s how to interpret that information, using EUR/USD — or the euro-to-dollar exchange rate — as an example:

The currency on the left (the euro) is the base currency.

The currency on the right (the U.S. dollar) is the quote currency.

The exchange rate represents how much of the quote currency is needed to buy 1 unit of the base currency. As a result, the base currency is always expressed as 1 unit while the quote currency varies based on the current market and how much is needed to buy 1 unit of the base currency.

If the EUR/USD exchange rate is 1.2, that means €1 will buy $1.20 (or, put another way, it will cost $1.20 to buy €1).

When the exchange rate rises, that means the base currency has risen in value relative to the quote currency (because €1 will buy more U.S. dollars) and conversely, if the exchange rate falls, that means the base currency has fallen in value.

A quick note: Currency pairs are usually presented with the base currency first and the quote currency second, though there’s historical convention for how some currency pairs are expressed. For example, USD to EUR conversions are listed as EUR/USD, but not USD/EUR.

What is Forex Trading Software?

Forex trading software is an online trading platform provided to each XM client, which allows them to view, analyze and trade currencies, or other asset classes.

In simple terms, each XM client is provided access to a trading platform (i.e. software) which is directly connected to the global market price feed and allows them to perform transactions without the help of a third party.

Who are Forex Trading Market Participants?

Forex trading market participants can fall in any of the following categories:

1. Traveler’s or overseas consumers who exchange money to travel overseas or purchase goods from overseas.

2. Businesses that purchase raw materials or goods from overseas and need to exchange their local currency to the currency of the country of the seller.

3. Investors or speculators who exchange currencies, which either require a foreign currency, to perform trading in equities or other asset classes from overseas or either are trading currencies with the aim of making a profit from market changes.

4. Banking institutions that exchange money to service their clients or to lend money to overseas clients.

5. Governments or central banks that either buy or sell currencies and try to adjust financial imbalances, or adjust economic conditions.

Three Ways to Trade Forex

There are three different ways to trade forex, which will accommodate traders with varying goals:

1. The spot market. This is the primary forex market where those currency pairs are swapped and exchange rates are determined in real-time, based on supply and demand.

2. The forward market. Instead of executing a trade now, forex traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed upon amount of currency on a future date.

3. The futures market. Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.

The forward and futures markets are primarily used by forex traders who want to speculate or hedge against future price changes in a currency. The exchange rates in these markets are based on what’s happening in the spot market, which is the largest of the forex markets and is where a majority of forex trades are executed.

Forex Terms to Know

Each market has its own language. These are words to know before engaging in forex trading:

Currency pair. All forex trades involve a currency pair. In addition to the majors, there also are less common trades (like exotics, which are currencies of developing countries).

Pip. Short for percentage in points, a pip refers to the smallest possible price change within a currency pair. Because forex prices are quoted out to at least four decimal places, a pip is equal to 0.0001.

Bid-ask spread. As with other assets (like stocks), exchange rates are determined by the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers require to sell (the ask). The difference between these two amounts, and the value trades ultimately will get executed at, is the bid-ask spread.

Lot. Forex is traded by what’s known as a lot, or a standardized unit of currency. The typical lot size is 100,000 units of currency, though there are micro (1,000) and mini (10,000) lots available for trading, too.

Leverage. Because of those large lot sizes, some traders may not be willing to put up so much money to execute a trade. Leverage, another term for borrowing money, allows traders to participate in the forex market without the amount of money otherwise required.

Margin. Trading with leverage isn’t free, however. Traders must put down some money upfront as a deposit — or what’s known as margin.

Risks of Forex Trading

Because forex trading requires leverage and traders use margin, there are additional risks to forex trading than other types of assets. Currency prices are constantly fluctuating, but at very small amounts, which means traders need to execute large trades (using leverage) to make money.

This leverage is great if a trader makes a winning bet because it can magnify profits. However, it can also magnify losses, even exceeding the initial amount borrowed. In addition, if a currency falls too much in value, leverage users open themselves up to margin calls, which may force them to sell their securities purchased with borrowed funds at a loss. Outside of possible losses, transaction costs can also add up and possibly eat into what was a profitable trade.

On top of all that, you should keep in mind that those who trade foreign currencies are little fish swimming in a pond of skilled, professional traders — and the Securities and Exchange Commission warns about potential fraud or information that could be confusing to new traders.

Perhaps it’s a good thing then that forex trading isn’t so common among individual investors. In fact, retail trading (a.k.a. trading by non-professionals) accounts for just 5.5% of the entire global market, figures from Daily Forex show, and some of the major online brokers don’t even offer forex trading. What’s more, of the few retailer traders who engage in forex trading, most struggle to turn a profit with forex. Compare Forex Brokers found that, on average, 71% of retail FX traders lost money. This makes forex trading a strategy often best left to the professionals.