A common question that is asked by new entrants into the foreign exchange market is how Forex trading works, and is even asked by those who have already been trading Forex for some time – as the market is the largest financial market in the world and a very fascinating one as well and not always so easy to grasp. Global FX market turnover (i.e. the amount of trading) has also been on the rise, as FX is accepted more and more as a viable asset class for retail traders and households looking to diversify their investment portfolio.
Because of the markets’ size and complexity, there is no single answer to define how the market works in absolute terms, but generally speaking the essence of Forex trading is the exchanging of foreign currencies at specific exchange rates that are priced on the spot, in real-time (in the present moment) and then which may subsequently change over time and thus affect their future values (i.e. how much they are worth relative to each other).
The excerpt to the left from the latest Triennial Survey of Central Banks shows the FX markets’ growth over nearly the last 20 years. Now moving below to providing details on how forex trading works for beginners, we will review some basic fundamentals to help get you started.
Transferring Risk To Speculators
Since exchange rates can fluctuate over time, some participants that come into the fx market to trade may have a need for the currency, or use it for commercial purposes or to hedge a transaction denominated in a foreign currency (such as with an import or export), or the reason for trading could be purely for speculation where risk is assumed in order to have a chance to make a profit while risking a loss.
This is the cornerstone of investing, which is placing capital at risk in the hope that said capital will appreciation over time due to underlying fundamental and economic drivers including supply and demand which affect market prices. In FX the market is also affected by observation, which typically uses technical analysis a method for analyzing historical and current price behavior, and using trend lines and mathematical formulas or statistics to draw conclusions on future price direction.
Trading on the spot, is known as spot FX transactions in foreign exchange markets, and while other forms of transactions exist in Forex (such as forwards, swaps, and options) , this article will focus on Spot FX -as it is the most widely used by traders -and makes up nearly the largest majority of the FX market-share, and is based on live Forex quotes which update in real-time from moment to moment while the market is open and trading (which is 24 hours nearly 6 day per week).
Easy way to Understand How Forex Trading Works
The way Forex trading works is that each transaction has two sides, or two party’s to the trade, one side is a buyer and one side is a seller. Thus each trade always includes a buyer and seller, as well as two different currencies, such as if the seller was selling Euros in order to buy US Dollars from the Buyer, the buyer would be effectively selling their US Dollars to the Seller in order to buy the Sellers Euros.
Imagine you had apples and wanted to trade them for oranges, you would be looking to sell apples and buy oranges, and would need to find someone who had oranges and was willing to sell them to you and buy your apples. Spot FX works the same, except the rate that determines how many apples are exchanged for oranges is constantly changing.
Like Trading Apples and Oranges?
Obviously trading Forex is not as simple as trading fruits and vegetables, but the analogy for trading has its roots in ancient times when such commodities had respective prices where they could be exchanged and that made similar fluctuations over time and thus created the chance for hedging and risk to be transferred between those who wants to take risk versus those who wanted to avoid it -while protecting their assets or trying to grow them.
So while this trading, as in the case above with example of a buyer and seller, appears as one transaction, it actually has two sides, and the trades are sometimes both counted as one (matched up) or double-counted, although that is just for accounting and measuring purpose and has no effect on the trading results. Nonetheless, this is a very basic underlying driver of how forex trading works.
Here is an example of what the above trade could look like:
- Trader A) Sells 10,000 Euros to Buy 14,000 US Dollars, EUR/USD exchange rate = $1.40
- Trader B) Buys 10,000 Euros by Selling 14,000 US Dollars, EUR/USD exchange rate = $1.40
Thus Trader A sold 10,000 EUR/USD @ $1.40, and trader B Bought 10,000 EUR/USD @ $1.40
If the price of the EUR/USD subsequently went to $1.39, trader A would have a $100 profit as the 10,000 Euros they sold for $14,000 can now be bought back for $13,900, and trader B would have a loss of $100 as the 10,000 Euros they bought for $14,000 are now worth $13, 900 if they were to sell them. The $100 profit for one side, is the $100 loss for the other, and thus capital is transferred in this manner, as prices change and transactions are made at the underlying exchange rates.
Such transactions are happening many thousands of times per second, and the most recent estimates which surveyed central banks and major financial institutions participating in foreign exchange markets estimated that $5.3 trillion dollars’ worth of currency is traded on average per day (using April 2013 data) according to the Bank for International Settlements.
Using the Right Counter-Party To Open Your Live Forex Trading Account
The Spot FX market which consist of a large portion of the overall market, consists of transactions between buyers and sellers, as described above. While the example above used traders as the party’s to the trade, in reality the party to each trade can vary.
This is also because the FX Markets are scattered and decentralized, since there is no one main exchange where all FX trading is conducted, the fragmented nature of the market makes it more diverse and across a diverse landscape as well as with diverse technologies, platforms and trading systems.
For example, on the other side of a trade could be a broker, an exchange, a clearing house, a bank, fund manager, hedge fund, individual, corporation, non-profit organization, trust, or other entity. No matter who is on the other side of the transaction, the trade itself should be maintained by a counter-party or brokerage that oversees the transaction and both sides to it.
This way there is no reliance on the other party to the trade, but instead on the brokerage or bank/custodian that is acting as an intermediary in between each trade. For this reason it is important to read the customer account agreement when establishing live forex trading account, as this will explain the nature of the legal relationship that is created between you and your broker.
What Affects Profit and Loss
In addition, the actions of the other side of the trade have not bearing on the trade once its already executed. What will determine the resulting profit or loss or break-even, are the amount of margin available in the account, the number of pips if any that were specified in a stop-loss order properly attached to the trade already, as well as the number of pips for any limit order attached to the trade, and then whether the market reaches either of those orders’ prices, and the amount of time it may take to do so.
Traders must focus on how to trade successfully, by incorporating proper money management such as the forex risk management secret explained on Forex Blog, and applying it into a well-defined trading methodology tailored uniquely for their specific trading goals.
This brokering of transactions provides both the execution capabilities, matching, price discovery, and often the technology and tools to trade, in addition to proper licenses and regulatory approval to operate such business and holds customer assets with fiduciary responsibility. Therefore choosing the right broker is also an important first step in understanding how Forex trading works, and for this reason Forex Blog recommends the online brokerage WorldWideMarkets (WWM) which operates multiple regulated brands.