Whether you’re a complete beginner to Forex trading or have already placed a few trades, you’ll find useful information in our guide on how online Forex trading works. We’ll explain everything you need to know to jump-start your trading career, from the basics of trading, and what currencies are traded on Forex, to the various ways of analysing the market.
Forex trading – how it works
Let’s first explain what Forex is and how it works. Forex is the largest financial market in the world, with an average daily turnover of around $5 trillion. This enormous trading volume exceeds other major markets, including both the stock and bond markets - combined.
Back in the 70s and 80s, the big players in the market included large investment and commercial banks, hedge funds, governments and central banks, multinational companies and high net-worth investors. While the Forex market wasn’t accessible for small traders a few decades ago, advancements in technology and the internet now allow even small traders to trade on the Forex market.
It’s estimated that retail Forex traders account for around 5% of the total daily trading volume, which represents around $250 billion. Still, the size of the market makes it impossible to move exchange rates to a notable extent with a single order. Even investment banks with their multi-billion-dollar orders are able to find buyers and sellers relatively fast, which makes the Forex market not only the largest, but also the most liquid financial market in the world. The following chart shows the largest Forex players among banks.
Exotic currencies are all other currencies which are not actively traded on the Forex market. Examples of exotic currencies are the Turkish lira, Argentina peso, Mexican peso, South African rand, Russian ruble, Czech krone, and so on. Exotic currencies are way less liquid than majors (meaning there are less buyers and sellers), which makes them way more volatile than major currencies. While exotic currencies have significant profit potential, they should usually be avoided by beginners to prevent large losses.
Just like stocks, all currencies have their own personalities when it comes to trading. Some of them behave as safe-havens and appreciate when investors don’t want to take on risk on the market – examples being the Japanese yen and Swiss franc. Some currencies are heavily correlated with the price of commodities, such as the New Zealand dollar, Australian dollar, Canadian dollar, and most South American currencies. Traders need to know how currencies behave under certain conditions to make the most out of their Forex trading.
How are currencies quoted?
All currencies are quoted in pairs. This means, you’re actually trading two currencies simultaneously: in a long position, the first currency is bought and the second is sold; and in a short position, the first currency is sold and the second bought.
The first currency of a currency pair is called the base currency, while the second is called the counter currency. If we take EURUSD for example, euro would be the base currency, and the US dollar the counter-currency. If you want to buy the EURUSD pair, you’re actually buying the euro and selling the US dollar at the same time.
All currencies have their characteristics and behave differently during certain market conditions. Safe-havens such as the Japanese yen, US dollar, and Swiss franc usually appreciate when investors are risk-averse, while risk currencies such as the Australian and New Zealand dollar tend to fall in value during those times.
Some currencies can also be linked to the price of commodities. Of the major currencies, some commodity currencies include the Canadian dollar, New Zealand dollar, and the Australian dollar, and most South American currencies comprise the exotics, including the Russian ruble and so on. These currencies exhibit a high correlation with the price of the country’s main exporting commodity – usually oil, gas, iron ore, and gold. Traders need to follow these commodities when they’re trading commodity-related currencies.
How currencies are quoted?
You’ve probably already noticed that all currencies are quoted in pairs. A Forex pair consists of the base currency and the counter currency, and the exchange rate represents the price of the base currency expressed in terms of the counter currency.
To make this concept clearer, let’s take an example. The GBP/USD pair is the British pound vs. US dollar pair. In this case, the pound is the base currency (left currency), while the US dollar is the counter currency (right currency). If GBP/USD currently trades at 1.30, this means that one pound buys 1.30 US dollars, or “it takes 1.30 US dollars to buy one pound”.
A rise in this exchange rate would mean that one pound buys more US dollars than before (i.e. the pound appreciated), while a fall in the exchange rate would mean that one pound now buys less US dollar than before (i.e. the dollar appreciated). When buying or selling a Forex pair, you’re always buying or selling the base currency relative to the counter currency.
Forex pairs that include the US dollar as either the base or counter currency are called major pairs. These are the most liquid pairs on the market, as the US dollar is involved in around 80% of all daily Forex transactions. If the pair includes two of the remaining seven major currencies but excludes the US dollar, these pairs are called cross-pairs. The following table shows the average daily volatility of some major and cross-pairs on the Forex market, expressed in pips.
When measuring exchange rate movements, Forex traders often refer to the number of pips that a pair has moved. A pip is simply the fourth decimal place of an exchange rate. If GBP/USD rises from 1.3000 to 1.3025, the British pound rose 25 pips against the US dollar.
What do you need to trade on Forex?
Before we dig deeper into how Forex trading works, let’s see what you need in order to start trading on the market. All you need is a computer with internet access, a brokerage account, and a trading platform.
Since you’re reading this guide on how Forex works, let’s assume that you have a computer with internet. This leads us to the remaining two prerequisites for trading – a brokerage account and a trading platform.
Opening a brokerage account is pretty simple and can be done in a few minutes by filling out the register form on the broker’s website. After that, the broker will check your application and activate your account, which makes it then ready for funding. Many brokers accept credit and debit cards, online payment services, and bank wire transfers for deposits, so you can choose the way that is most convenient for you.
Once you deposit money into your account, you can download the trading platform directly from your broker’s website. The most popular trading platform is MetaTrader, but your broker may also offer a platform developed in-house, so your best bet is to check beforehand what’s on offer.
When your account is fully activated, funded, and your trading platform installed on your computer, you can log in to your account and immediately start trading. It’s as easy as it gets.
Hint: It’s a good idea to start with a risk-free demo account first and move on to a real account only when you’re able to stay consistently profitable on a demo account.
How does the Forex market work?
The Forex market is an OTC (over-the-counter) market, which means there’s no centralised exchange to trade currencies. Instead, currencies are traded during major Forex trading sessions, which include the New York session, the London session, the Sydney session, and the Tokyo session.
Since these financial centers span across different timezones, you can trade on the Forex market 24 hours a day - except on weekends, when the market is closed. This is a major advantage of the Forex market compared to stocks, which can be traded only during regular open market hours of a stock exchange.
The New York and London sessions are the most liquid Forex sessions with the highest daily trading volume, so you would like to trade during these sessions if you want to be a day trader. There is also a part of the day when these two sessions overlap, called the “NY-London overlap”. This is when the market experiences the highest volatility and highest trading volume during the day. The following table shows the opening hours of the mentioned Forex trading sessions.
Be cautious when opening trades in the beginning of the Sydney session at 21:00 GMT, as this is also the time when the New York session closes. The spread, i.e. transaction cost of a trade, can widen significantly in these few minutes, so it’s better to wait for Sydney to heat up before placing a trade.
How do I make profits on Forex?
This is probably the most interesting question for beginners, so let’s answer it with a few examples. We’ve already said that Forex traders try to buy a currency cheap and sell it later at a higher price. For example, if EUR/USD currently trades at 1.20, a trader anticipates that the exchange rate may rise in the future, they would buy the pair at 1.20 and sell it later for a profit. However, if the exchange rate goes in the opposite direction, our trader would incur a loss.
To prevent large losses, you need to use stop-loss orders on all your trades. A stop-loss order automatically closes your position when the price reaches the pre-specified stop-loss level. If you place a 100-pip stop-loss, your broker will automatically close your trade when the price goes against your position for 100 pips. Stop-losses are important for risk management, so make sure that the total potential loss of your trade represents only a small percentage of your trading account size.
Take-profit orders are very similar to stop-loss orders, only these close your position when the price goes in your favour. A 100-pip take-profit order would close your trade when you’re 100 pips in profit. While it’s not mandatory to place take-profit orders on all your trades, it’s highly advisable.
Forex – How it works: analysing the market
To find a good trade setup, Forex traders need to analyse the market. Without proper analysis, all you would be doing is betting on the outcome of a trade.
There are two main ways to analyse the market: fundamental analysis and technical analysis.
Fundamental analysis tries to determine the intrinsic, or fair value of a currency. Many factors affect the exchange rate of a currency pair, including economic growth, inflation rates, monetary policies, retail sales value and so on. Fundamental analysts follow these macro-numbers and analyse whether the current exchange rate is overvalued or undervalued compared to the “fair” exchange rate. The following table shows the times when major reports are published.
Technical analysis, on the other hand, relies only on the price-chart to find trading opportunities. Technical analysis is based on three basic assumptions, which are that (1) markets like to trend, (2) the price discounts all fundamental data, and (3) history repeats itself.
Technical traders try to find familiar patterns in the chart which have worked in the past, assuming that they will work equally well in the future. Most retail traders are technical traders, but if you combine fundamental and technical analysis, you’ll probably have a better trading performance than relying solely on one type of analysis. The best way to learn how Forex trading works is by regularly analysing the market and accumulating trading experience along the way.
Final words – Forex trading and how it works
If you carefully read through this guide, you should have an understanding of how Forex trading and currency trading work, and what your next steps in becoming a Forex trader are. Forex is the marketplace of the world’s currencies and a confluence of factors work simultaneously in moving exchange rates up and down.
The best way to think about how Forex works is by looking at the supply and demand forces on a currency. If the supply of a currency increases (perhaps as the central bank lowers interest rates), its value usually goes down. On the other hand, if the demand for a currency increases (e.g. economic growth is expected to pick up), its value usually goes up.