Forex, short for foreign exchange, is nothing more than the conversion of one currency into another. Read this guide to find out everything you need to know about forex trading, including what forex trading is, how to trade and with which tools.
What is forex trading?
Trading forex online means trading one currency for another. When you do general trading on forex, you always exchange currency pairs, i.e. you sell one currency to buy another.
Currencies in the forex world are listed according to their international denomination, i.e. with a three-letter capital code. Generally, the first letters indicate the country of the currency, while the third letter symbolizes the currency itself. So, USD stands for US dollar, JPY for Japanese yen, and so on.
If you display a currency pair in this USD / JPY order it means that you are buying US dollars and selling Japanese yen.
This is just one of the many most popular currency pairs in the forex world. Other popular pairs are USD / EUR and GBP / EUR - GBP stands for British pound.
To tidy up, most providers divide currency pairs into the following categories:
- Major pairs - Seven major currency pairs that represent approximately 80% of the world's forex trading. They are: EUR / USD, USD / JPY, GBP / USD, AUD / USD, USD / CHF, NZD / USD and USD / CAD.
- Exotic Pairs - Exotic Pairs are when a major currency is traded against one from a small or emerging economy. Included in these pairs are USD / HKD, USD / SGD, USD / THB, USD / MXN, USD / ZAR, USD / NOK and many more.
- Minor pairs - Currency pairs that are traded less frequently, often feature major currencies against each other rather than against the US dollar. It includes: EUR / GBP, EUR / CAD, EUR / YEN, EUR / AUD, EUR / CHF, GBP / CHF, GBP / JPY, AUD / JPY, CAD / JPY and more.
Most trading or mirror trading is done by banks or individuals, looking to buy a currency that they think will increase in value against the currency they sell. If you have traveled abroad and changed your money, for example, you too have been trading without knowing it.
How does forex trading work?
Institutional forex trading takes place directly between two parties in an over-the-counter (OTC) market. This means that the exchange is not centralized (like trading on the stock market), as the trading library is managed by a global network of organizations and banks.
Those who operate in day trading do so in four different time slots for the four main forex markets: Tokyo, London, New York and Sydney. Since forex trading is not centralized, it is possible to trade or auto trade 24 hours a day.
Most forex traders do not actually buy a currency, but speculate on the price of the pair. That is, they make a forecast on the price that one currency will have in respect of the other in a specific period of time, short or long term.
The simplest way to do forex trading is to open an account with a professional broker, which offers trading apps for beginners, if you are a beginner, or professional trading apps for the more experienced.
Most of these brokers not only offer forex trading, but will also allow the user to do commodity trading, bitcoin trading, CFD trading and much more. Among the most popular brokers we undoubtedly have eToro, which among its proposals also includes copy trading, or the ability to copy what the most experienced traders do.
Derivatives in the trading world allow the trader to speculate on the price movement of a currency, without actually owning it. For example, when trading forex with a platform, you can bet on the direction of the price that that pair will move towards. If the forecast is correct it will result in a profit, otherwise there will be a loss.
Three different types of forex market
Forex trading is possible in three different ways: spot, forward and future.
- Spot forex market: the physical exchange of a currency pair, which takes place at the exact point where the transaction is settled, ie on the spot (literally “on the spot” in English). Spot Forex derivatives are offered over-the-counter by providers such as eToro and Plus500.
- Forex forward market: it is a contract in which you agree to buy or sell a currency for a certain amount and to be determined on a future date or in a range of future dates.
- Forex futures market: an exchange-traded contract to buy or sell a certain currency for a specified amount at a price and date set in the future.
Base currency and listed currency
The first currency listed in a forex pair is called the base while the second is called the quote currency. The price of a forex pair is how much one unit of the base currency is worth in the quoted currency.
Here's an example:
In the GBP / US pair, GBP is the base currency while USD is the quote currency. If the GBP / USD pair is trading at 1,35361 it means that one pound is worth $ 1,35361.
If the value of the pound rises against the dollar, a single pound will be worth more dollars and the price of the pair will rise.
If it falls, the price of the pair will fall. So, if you think the base currency in a pair might strengthen against the quote currency, you can buy the pair (by going Long). If you think it will weaken, you can sell the pair (by going Short).
What is leverage in forex trading?
In the spot forex market there is a very important advantage, which is the possibility of opening a position on the basis of a predetermined leverage. Leverage allows the trader to increase their exposure relative to the market, without having to commit as much capital.
When trading with leverage, there is no need to pay the full trade amount upfront. Rather, a small amount called Margin is invested. When you close a leveraged position, the profit or loss is based on the full size of the trade.
This means that leverage can increase profits, but also losses. Also, in the worst case, the losses can exceed the deposit starting. It is therefore important to trade with leverage, especially to learn how to manage risk.
Speaking of learning, if you think you are trading forex and have success or luck like when you first enter a casino, you are wrong. It is necessary to study, take an online trading course at least to learn the basics. Forex trading is not a betting market, although many think so (before losing all their capital).
What makes the forex market move?
As in most financial markets, forex is primarily driven by supply / demand strength. Understanding what affects these factors is important for successful forex trading.
The supply is controlled by central banks, which have a major impact on the price of currencies when they announce the adoption of new measures. Quantitative easing, for example, involves injecting new money into an economy, causing the price of its currency to drop accordingly.
Central banks also control the base interest rate for an economy.
If you buy an asset in a currency with a high interest rate, you can get higher returns. This means that if a country raises its interest rates, most investors will do their operations in that country, while improving its economy and the value of the currency itself.
However, higher interest rates can also make operations such as borrowing money more difficult. If it costs a lot to borrow, investors are more reluctant and the currency itself could weaken.
Banks and other investors tend to want to put their capital into economies that have better prospects (of course). For this reason, if positive news hits the markets of a particular region, it will encourage investment and increase demand for that region's currency.
Unless there is an increase in supply for the currency in parallel, the disparity between supply and demand will increase its value. Likewise, negative news can discourage investors and lower the value of the currency. As a result, the value of the currency in most cases reflects the health of the region it represents.
Among the most important and most influencing news on the markets, we undoubtedly find:
- Inflation data
- Production reports
- Retail sales
Market sentiment, which usually reacts to news, can also play an important role in determining currency prices. If traders think a currency is headed in a certain direction, it will trade in that direction and could convince other investors to follow, increasing or decreasing demand.
Forex trading is quite different from cryptocurrency trading, as it can be predicted with greater accuracy. However, to be successful it is necessary to understand how it works, to practice (perhaps with a demo account) and to study a lot, starting from the ABC.