What is Forex

What is Forex Trading and How Does it Work

Forex

What is Forex Trading? This is definitely one of the most asked questions in the public domain. Most find adverts all over social media and even on search engines showing how some traders have become millionaires overnight.

I think you are here since you come across some of those adverts either online or offline about Forex trading. Some of these adverts are portraying rich guys driving or showing off with very expensive cars or houses. Therefore you decided to find out more of this forex trading.

I am going out to cover the following areas to make you understand what is Forex trading in simple way

In general, Forex trading, FX trading, Spot trading, or Foreign Exchange trading, is the simultaneous exchange of one country’s currency for that of another. So in short Forex means Foreign Exchange or currency market.

How big is the Forex Market

Forex market is the world’s largest form of exchange, trading around $5 trillion every day. Apart from that, it is open to importers and exporters, international portfolio managers, multinational corporations, speculators, day traders (you and me), and hedge funds. All use the Forex market in a different manner. Some use it to speculate, pay for goods and services, transact in financial assets, or to reduce the risk of currency movements by hedging their exposure in other markets.

How does Forex Trading work?

The way Forex trading works is quite simple. Just like any other form of speculation, you want to buy a currency at one price and sell it at a higher price (or sell a currency at one price and buy it at a lower price) in order to make a profit. The participants in the Forex market can, therefore, make money, either way, by selling or buying currencies.

Some are wondering how can that be. Don’t be confused, just know the price of one currency is measured against another currency always, of course, determined in another currency. For instance, the price of one Euro could be measured as, say, two US dollars, if the exchange rate between EUR and USD is exactly.

In Forex terms this value for the Euro would be represented as a price of 2.0000 for the forex pair EUR/USD. Currencies are grouped into pairs to show the exchange rate between the two currencies; in other words, the price of the first currency in the second currency.

What is traded on the Foreign Market?

Forex can be confusing for beginners because you’re not buying anything physical. When you are buying a currency, think of it as if you are buying a share in a particular country. For instance, when you buy Kenyan Shilling, you are in effect buying a share in the Kenyan economy.

The value of a currency is a direct reflection of what the market thinks about the current and future health of a particular country. Therefore, the exchange rate of a given currency versus other currencies is the reflection of the overall condition of that country’s economy, compared to other countries’ economies. The Forex market is determined by a number of factors.

  1. Political stability
  2. Inflation
  3. Interest rate
Can the Forex Market be Manipulated?

In some cases, governments may try to control the price of their currency by buying extensively in order to raise the price of flooding the market in order to lower the price.

Nevertheless, it is impossible for one force to control the market for any length of time due to the gigantic volume of the Forex market, market forces will prevail in the long run, making currency the most open
and fair investment opportunities available. Unlike other financial markets, the FX spot market has neither a physical location nor a central exchange. (Except for a small portion of the world’s daily volume which is traded on the Chicago Mercantile Exchange).

The Forex market is considered an Over-the-Counter (OTC) or ‘interbank’ market, because the entire market is run within a network of banks and brokers, continuously over a 24-hour period. (OTC implies that you have to trade with a specific bank or broker when you buy and sell a currency)

Which are the most traded Currencies

The US Dollar is the most wildly traded currency globally, being on one side of about 90% of all transactions. The European Euro comes in the second with about 35%, while only 3% of all transactions in the Forex market do not involve either the Euro or the US Dollar, underlining the importance of the USD and EUR in the Forex market.

Are you astonished? Just look at your country, most overseas transactions are quoted in which currency? That tells you why the dollar is an important currency.

Below a table has been attached of common currencies.

SymbolCountryCurrencyNickname
USDUnited StatesDollarBuck
EUREuro MembersEuroFiber
JPYJapanYenYen
GBPGreat BritainPoundCable
CHFSwitzerlandFrancSwissy
CADCanadaDollarLonnie
AUDAustraliaDollarAussie
NZDNew ZealandDollarKiwi

Some commonly traded Forex pairs (known as ‘major’ pairs) are EUR/USD, USD/JPY and EUR/GBP, but it is also possible to trade some exotic like South African Rand (ZAR), Turkish Lira (TRY) and HongKong Dollar (HKD). Exotics are currencies that are not so frequently traded the market, hence they have less liquid and so the trading spreads are wider.

How to Read a Forex Quote

It’s a general rule, that each currency has to have three letters symbol, which is used in Forex quotes. The first two letters identify the name of the country while the third letter identifies the name of that country’s currency. For example AUD (Australian dollars), JPY (Japanese Yen), CHF (Swiss francs), and CAD (Canadian dollars).

Example: EUR/USD 1.2500 means that one Euro is traded for 1.25 USD.
As such the Base currency is always equal to 1 monetary unit of exchange.
The dominant base currencies are, in order of frequency, the Eur, GBP, and
USD. When a currency is quoted against the US Dollar it is called a direct
rate. Any currency pair that does not trade against the US Dollar is referred
to as a cross rate.

The Pip

The pip is the smallest unit of change in which a currency pair can move. In the Forex world, currencies are traded in fractions of a Cent, or Euro, and so on. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit, with four decimal points to follow. For example, EUR/ USD equals to 1.1867. In this example, a single pip equals the smallest change in the fourth decimal place – that is, 0.0001.

Therefore, if the quote currency in any pair is USD, then one pip
always equals 1/100 of a cent. The only notable exception to this rule is the USD/JPY pair
where a pip equals $0.01. Alternatively, you can use the position size calculator to calculate the number of pips in a trade.

How to calculate pips

Example: You sell the EUR/USD, which is quoted with five digits in all out of which 4 decimals, at
1.1867 and sell it later at 1.1843. The difference would be +24 pips, or. 0024. However, in the case of the USD/JPY currency pair, one has to make a note that it is quoted with only 2 decimals. And so if you bought the USD/JPY at 109.51 and it then went down to 110.31 where you have sold it, the difference would be -20 pips, or. 20 pips loss. The pip difference would determine your calculation of profit/loss on the trade. As mentioned earlier, the quote currency is translated into a certain number of units of the base currency. For example a quote of EUR/USD at 1.1867 means that, for every 1 EURO, you get 1.1867 USA dollars.

When the price of the quoted currency goes up, it indicates that the base currency is becoming stronger and so one unit of the base currency will buy more of the quote currency. on the other hand, if the price of the quote currency falls, the base
currency is becoming weaker.

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