What Is Forex and How Does It Work?

Disclaimer: The content below is for educational and informational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. Investing involves risks, including potential loss of capital. Past performance is not indicative of future results. Investors should consult a qualified financial advisor or conduct their own research before making investment decisions.

If you have travelled to another country, you may have handed over your local currency and received a certain amount of the currency of the country you’re visiting. When you did that, you participated in the foreign exchange market, often abbreviated as forex (FX).

In this forex trading guide, we will break down the forex market basics so you can understand how it works, why people do it, and how you can get started for educational purposes only.

What Is Forex?

Forex is the process of changing one currency into another.

Unlike the stock market, where you buy shares of a company like Apple or Google, the forex market is where you buy and sell money (currencies). It is the world's largest financial market. To give you an idea of its size, billions of dollars are traded on the stock market every day. In the forex market, trillions of dollars worth of currencies are traded every single day (based on publicly available market estimates).

The market is open 24 hours a day, five days a week. It only closes on the weekends. Because it is a global market, when the sun sets in New York, markets in Tokyo and Sydney are just opening.

Forex Trading Explained: How It Works

In this forex market overview, the most important thing to know is that currencies are always traded in pairs. You cannot simply buy Euros. You must sell another currency to get that Euro.

Understanding Forex Currency Pairs

When you look at a trading screen, you will see two currencies listed together. These are called forex currency pairs.

A common pair is the EUR/USD.

• The first currency (EUR): This is called the Base currency.
• The second currency (USD): This is called the Quote currency.

The price tells you how many units of the quote currency you need to buy 1 unit of the base currency. For example, if the EUR/USD price is 1.10, it means 1 Euro costs 1.10 US Dollars.

Why Do People Trade?

Most people trade forex with the objective of making a profit. They hope the value of one currency will rise relative to another; however, profits are not guaranteed and losses may occur.

Example: You think the Euro will strengthen against the US Dollar. You buy Euros. If the Euro goes up in value, you sell them back for more Dollars than you started with. The difference is your profit (before costs, fees, and taxes, where applicable).

Forex for Beginners: Key Terms to Know

Before you learn how to trade forex, you need to speak the language. Here are some simple definitions:

• Pip: This stands for percentage in point. It is the smallest price move a currency can make. Most pairs are priced to four decimal places (0.0001).
• Spread: The difference between the buy and sell prices. This is how brokers make their money and may vary depending on market conditions and broker pricing models.
• Leverage: This is like a loan from your broker. It allows you to trade with more money than you actually have in your account. While it can increase profits, it also increases the risk of losing money quickly and may result in losses exceeding your initial investment.
• Lot: Currencies are traded in batches called lots. A standard lot is 100,000 units of currency, but beginners usually start with micro lots (1,000 units).

How Forex Trading Works?

How do you actually make a trade? It happens through a computer or a phone app provided by a trading platform or broker.

1. Going Long (Buying): You buy a pair if you think the base currency will rise.
2. Going Short (Selling): You sell a pair if you think the base currency will fall.

Because you are always comparing two currencies, you can make money whether the market is going up or down in theory. You just have to be on the right side of the move; however, market movements are unpredictable and losses can occur.

What Makes Currency Prices Move?

Currencies reflect a country's economic health and market expectations. Here are a few things that cause prices to change:

• Interest Rates: If a country raises interest rates, its currency usually strengthens because investors want to earn the higher interest, although this relationship is not guaranteed.
• Economic News: Reports on jobs, inflation, and growth (GDP) move the market.
• Politics: Elections, wars, or new laws can cause big changes in currency value.

How to Start Forex Trading?

If you are a beginner, you might be wondering how to start forex trading safely and responsibly. Follow these steps:

1. Educate Yourself

Don't rush in. Read books, watch videos, and understand the risks. Forex is exciting, but you can lose money if you don't know what you are doing.

2. Choose a Reliable Broker

You need a broker to access the market. Look for one that is regulated by a recognised supervisory authority. This means they follow government rules to protect your money.

3. Open a Demo Account

Almost every broker offers a demo account. This is a practice account with fake money. It allows you to practice how to trade forex without any risk to real capital. Spend a few weeks or months practicing here first.

4. Create a Trading Plan

Decide how much money you are willing to risk. Never trade money that you need for rent or food. Most successful traders only risk 1% or 2% of their total account on a single trade, although this does not eliminate the risk of loss.

5. Start Small

When you finally move to a real account, start with a small amount. This helps you manage your emotions while you learn.

The Risks of Forex Trading

While forex for beginners can seem like a great way to make money, it is important to be honest about the risks and potential downsides.

• Volatility: Prices can move very fast. Sometimes they move hundreds of pips in a few minutes due to news.
• Over-leveraging: Using too much borrowed money is the number one reason new traders lose their accounts and may lead to rapid losses.
• Emotional Trading: Fear and greed can lead to bad decisions.

Conclusion

The foreign exchange market is a massive, fast-moving world that offers many opportunities as well as significant risks. By understanding the forex market basics, you now know that trading is simply the exchange of one currency for another with the aim of achieving a financial outcome, which may result in gains or losses.

Success in forex doesn't happen overnight. It requires patience, a good forex trading guide, and lots of practice. Use the tools available to you, like demo accounts and educational blogs, to build your skills while remaining aware of the risks involved.

Disclaimer: This content is for educational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. All investments involve risk, including potential loss of capital. Investors should consult professional financial advisors and consider their personal circumstances before making any investment decision.