What is Forex Trading? How to Trade Forex?

After getting an insight into the Forex market and its players, now it is time to understand how Forex trading truly works.

🟢 What is Forex Trading?

Foreign Exchange or Forex Trading is the activity of simultaneously buying and selling the currencies for purposes such as commerce, trading, or tourism. Simply put, you sell your currency (or money) to buy a different currency.

For example, you are traveling from the United States to France for a summer vacation. You would need to exchange your USD to EUR to buy things while you are in France. After all, there is no way that the stores in France accept cash payments in USD, right? So, to ease your transactions, you will sell your USD and buy EUR at a certain exchange rate.

This is called Forex trading at its fundamental level.

You might ask, then how do people make money by exchanging currencies?

Let’s say at the end of your vacation, you still have the same amount of EUR in your pockets because most of your transactions were done using credit cards. You will then need to exchange your EUR back to USD or resell the EUR in exchange for USD.

The price of EUR/USD in the market has unexpectedly increased and now you have more money than you had when you first exchanged your USDs.

How does Forex Trading Work?

Before delving further into Forex trading, let’s start with the fundamental principle of Forex trading: the relative price of a currency is always measured based on another currency. That is why in Forex trading, you always find currencies quoted in pairs: EUR/USD, GBP/USD, USD/JPY, etc.

The currency mentioned in front is called the BASE currency, and the one mentioned at the back is the QUOTE currency.

When you see a price quotation in the market that says EUR/USD 1.1800, it means that 1 EUR is valued at about 1.1800 USD.

Therefore, when you sell 100 USD, you will get 84 EUR in return.

However, if you decide to buy USD and sell 100 EUR at the same exchange rate, you will only get 118 USD in return. That is because the market perceives EUR to be more valuable than USD.

The Forex market is extremely dynamic, so price quotations change in a fraction of seconds. Forex traders benefit from these changes by obtaining as much profits as they possibly can.

Of course, you can still trade currency conventionally, meaning you buy a currency at a lower price and sell it later when the price increases.

In the above example, you start your trade on DAY 1 to buy EUR with 500 USD. On DAY 2, you see that the price of EUR has decreased, so you decide to add another 500 USD to buy more EUR. Finally, on DAY 3, you see that the EUR price has increased again, and you decide to sell all your EUR to buy back your USD. As a result, you gain 6.3 USD in profits from your trades.

It sounds very appealing, don’t you think? However, if the EUR/USD price decreases the next day, your trading will result in a loss.

How to trade Forex online?

Now, modern-day trading offers a better option for trading currencies – Online Forex trading, you simple open a Forex account and start trading various currency pairs online.

Unlike conventional currency trading, in online Forex trading, you do not buy a particular currency. Instead, you speculate on the currency price movements based on different analyses and perform your trading transactions based on your calculated speculations.

For example, one day, you read an important announcement on the news. Then, you speculate that the price of EUR/USD will rise significantly. Therefore, you decide to place a BUY order. Later that day, when the price of EUR/USD rises in value, you close your trade by placing a SELL order and receive your profits.

Then, on another day, there is a particular event that causes EUR/USD price to decline. Thus, you immediately place a SELL order from your account. Eventually, you will reap another profit when the USD price increases, and you close the trade by buying back the currency.

Now, the question is what if we make a wrong prediction?

Well, if your calculated speculation proves to be wrong and the currency prices move in the opposite direction, then your trade will result in a loss.

Various kinds of analyses are used in Forex trading, but the most common are Technical, Fundamental, and Sentiment analyses. You can choose to use any of them, but most professional traders highly recommend a combination of these analyses to come up with more specific speculation.

👌 1. Technical Analysis

In technical analysis, you speculate on the currency price by taking into account its movement history. Traders try to pinpoint similar patterns based on the price history and use them to predict the future price movement in the market using various analytical tools.

👌 2. Fundamental Analysis

Fundamental analysis relies more on economic factors such as supply & demand, interest rates, GDP, and inflation rates for currency price speculation. Using this analysis, traders can determine which currency will rise or fall in value based on the country’s economic situation.

👌 3. Sentiment Analysis

Currencies are relatively valued by the market. Traders use this relative value in the sentiment analysis and speculate based on the market sentiment using crowd psychology.

For example, when the market trend shows long positions and everyone is buying EUR/USD, you will choose to sell instead. That way, you will benefit from the price reversal, because when more people are buying the same currency, the number of buyers decreases. Therefore, at some point, these buyers will have to sell and the currency price will drop. Thus, you get a profit.

What are SPREAD, PIP, and LEVERAGE?

As the currencies in Forex trading are always measured in pairs, you will always see the following price quotation presented by most Forex brokers:

EUR/USD X.XXXX / Y.YYYY

The X is called the BID price, or your selling price to the brokers. And the Y is called the ASK price or the money you will get when you sell your currency to the brokers.

A Spread is a difference between the BID and ASK prices. For example:

EUR/USD 1.1000 / 1.006

Spread: 1.006 – 1.1000 = 6 pips

Currency prices move in PIPs, i.e., the fourth decimal place or second decimal place depending on the currency:

Example #1:

EUR/USD 1.8246 🡪 pip

Example #2:

USD/JPY 106.01 🡪 pip

Some Forex brokers even add a fifth or third decimal place—called a pipette—to create a better deal and more accurate pricing.

EUR/USD 1.8246³ / 1.8246⁸USD/ JPY 106.01⁵ / 106.02¹
That amount of money may seem very nominal. But imagine if you trade in a standard lot or 100,000 units of currency (USD-related):

6 pips = 0.0006 x 100,000 = 60 USD

It means that when you place a trade of 1 standard lot, with a price difference of 0.0006 pip, you can gain or lose 60 USD for each transaction.

In Forex trading, you can also trade via Leverage. However, this feature is commonly known as a double-edged sword. Because when you trade using leverage you either gain or lose proportionately.

For example:

Leverage allows you to trade in a larger amount than your existing capital. In the above example, with the same 1,000 USD, when you trade without leverage, you get only 0.1 USD for every 1 pip price difference because 1 pip is counted as 0.0001 x 1,000 = 0.1 USD or 10 cents. This is how much money you will gain or lose for each pip when you enter a trade with your original capital. (Check out Forex brokers with highest leverage)

On the other hand, if you trade using 1:50 leverage, the calculation will be:

1000 x 50 = 50,000 units of currency

Therefore, 1 pip in leveraged trading is measured:

0.0001 x 50,000 = 5 USD.

In the above example, you can trade up to 50,000 USD using 1:50 leverage with just 1,000 USD capital. It means that the pip value that determines your profits or losses will also increase, and so does the amount of money you gain or lose at the end of each trade.

What is Forex?

Forex Currency Pairs