What is forex trading — how does it work?

Forex trading, also known as foreign exchange trading or just FX trading, is the process of buying one currency while selling another at an agreed-upon price. The agreed-upon price is stipulated through the exchange rate.

FX trading is done through various ways, such as someone going on holiday to another country and exchanging their currency for the local currency. Other methods include businesses buying or selling products or services to clients in different countries where payment is made in their local currencies.

However, most forex market participants are only there to speculate on the price movements of different currency pairs to try and profit from these fluctuations.

Traders in the forex market buy and sell currency pairs such as the GBP/USD (Great British pound against the US dollar) and speculate on their price movements. The difference between the opening and closing price of the currency pair will determine if the trader makes a profit or a loss.

As mentioned above, forex trading is the process of exchanging one currency for another. A trader will buy one currency while simultaneously selling another currency.

Let’s take the GBP/USD as an example again; if a trader believes the price of GBP will rise against USD, they’ll open a long (buy) position by buying GBP. If they believe the price of GBP will fall against USD, they’ll open a short (sell) position.

Currencies are always traded in pairs, as seen above, with the first being the base currency and the second the quote currency.

Now, the forex market doesn’t have a centralised marketplace like the stock market. Instead, it’s all done electronically over the counter (OTC).

Every trade taking place in the forex market is done through a network of computers between traders all over the world. 

The forex trading hours are open 24 hours a day, five days a week, and the reason for this is that the FX market follows the time zones of main financial capitals such as Sydney, Tokyo, London, and New York.

Every market overlaps each other until it gets to the New York session. The Sydney session coincides with the Tokyo session, the Tokyo session then coincides with the London session, and the London session overlaps with the New York session.

As a result, the forex market can be pretty volatile during overlapping sessions, meaning rapid price changes occur regularly.

This is just a small fraction of how the overall forex market works; there are many more factors involved, and below, you’ll see those factors explained in detail to give you a better overview.

What is leverage in forex trading?

Leverage allows traders to gain greater exposure to the market by using less of their own capital. Leverage trading is done through derivative products such as spread betting or CFDs.

Leverage trading works by ‘borrowing’ a certain amount of funds from the broker to open a position together with a trader’s initial capital deposit. This allows them to control a bigger position with less money.

The forex market allows traders to trade with more leverage compared to other financial markets.

Trading with leverage can magnify profits or losses. This is because the profits or losses a trader might obtain are calculated on the overall size of the trade and not just their initial deposit size.

For this reason, trading with leverage might have to be done with caution, as it’s possible a trader could lose more than their initial deposit.

What is a spread in forex trading?

The spread in forex trading refers to the difference between a currency pair's ask (buy) and bid (sell) price. With currency pairs, there are always three amounts to look out for. The first one is the ask (buy) price, which is the price at which a trader opens a buy position.

The second is the bid (sell) price, which is the price at which a trader opens a short (sell) position.

The price in the middle is the spread; this price difference is more commonly known as the bid-ask spread.

In forex trading, especially with spread betting, you don’t pay commission on your open trades, so the spread is one of the ways a forex broker makes their money from traders.

What is a lot size in forex?

In forex trading, lots are units to measure the standard size of a forex trade. The reason behind lots is that price movements within forex are generally small; lots are used to increase the value of a pair when trading. There are four different types of lots traders have access to.

• Standard lot: These are 100,000 units of base currency
• Mini lot: These are 10,000 units of base currency
• Micro lot: These are 1000 units of base currency
• Nano lot: These are 100 units of base currency

What is a pip in forex?

A pip is a single unit of price movement for a currency pair. The measurement occurs at the fourth decimal place within the price. Let’s say GBP/USD is trading at $1.5485, and it moves up to $1.5486. It has moved one pip. However, if it moves from $1.5485 to $1.5585, it has moved up 100 pips.

Pip movements are the same throughout every currency pair except for pairs with JPY as the quote currency. This is because the value of the Japanese yen is much less than other major currencies.

So, instead of a single pip movement occurring at the fourth decimal place, in JPY pairs, it’s the second number after the decimal point. For example, USD/JPY trades at $135.88; a single pip movement upwards will place it at $135.89.

What is a margin in forex?

Margin goes hand-in-hand with leverage. Margin is the amount required to open a position through leverage. The trader’s preferred broker usually states margin requirements as an amount or percentage. The margin requirements will differ depending on the amount of leverage available.

If a trader experiences a certain amount of concurring losses, the broker will send them a margin call. This notification states that the trader’s margin has dropped below the required margin level.

To correct the situation, a trader will need to add more funds to their account or risk having all their open trades closed automatically by the broker.

Margin level determines the health of a trader’s account according to their used margin. If they have a high margin level, they have a healthy account. However, they might be more at risk if they have a low margin level.

What is base and quoted currency?

As previously stated, currencies are always traded in pairs. The first currency is known as the base currency, and the second currency is the quoted currency.

The first currency (base currency) will always equal one, while the second (quote currency) will show the amount needed to buy one base currency.

Let’s look at the example of GBP/USD. GBP is the base currency, and USD is the quote currency. If this pair is trading at 1.5685, it means if a trader wants to buy £1, they’ll need $1.5685.

Currency pairs are any two currencies trading against each other in the forex market. Currency pairs will fall under one of three categories: majors, minors, or exotics. 

Every currency pair will always appear as a three-letter code; the first two letters showcase the country the currency is from, and the last one showcases the name of the currency. So, if you look at AUD/USD, it is the Australian dollar and the US dollar.

• Majors: Major currency pairs comprise the world’s biggest currencies, such as the Euro and Pound. All major currency pairs include the US dollar because the US dollar is seen as the world’s primary reserve currency. The US dollar in major currency pairs can be the base currency, for example, USD/JPY. Or the quote currency, for example, EUR/USD.
• Minors: These currency pairs are also known as cross pairs. These pairs still include the world's major currencies. However, they don’t include the US dollar. For example, EUR/GBP or EUR/AUD. These currency pairs will see less liquidity because they don’t contain the US dollar.
• Exotics: Exotic currency pairs contain one major currency and another from any emerging currency. For example, USD/SEK (US dollar/ Swedish krona) or EUR/TRY (Euro/ Turkish lira).

Most traders might end up only trading major currency pairs because of the high liquidity it offers.

Traders can participate in the forex market in three different ways. Let’s take a closer look at each one in more detail.

Spot forex market

The spot market, which is an OTC market, is where the majority of traders trade. This market is also the basis of the entire article. The spot market provides the live prices for all currency pairs. If any trader opens a trade, they will use the prices listed on this market.

Forwards market

In the forwards market, also seen as an OTC market, two private parties agree to exchange currencies at a set price at a future date. Retail traders speculating on the price movements of forex pairs won’t necessarily be trading on the forwards market.

These markets are usually more for businesses and institutions that can customise the contracts to fit their trading needs.

Futures market

The futures market is the only one which is not an OTC market. Instead, it’s centralised and traded through an exchange such as the CME (Chicago Mercantile Exchange). This market allows for buying and selling a set amount of currency at a fixed price at a future date.

Futures contracts are binding where one party, the seller, takes on the potential risk that a currency's price might change in the spot market before the contract has ended.

There is no one-size-fits-all when it comes to forex trading strategies. Many strategies are available, and each comes with its pros and cons.

However, ultimately, choosing the right strategy will come down to personal factors relating to each trader, for example, the amount of time they have available to analyse the markets or their level of experience.

Strategies might be complex to remember, but as traders gain knowledge and experience over time, they could incorporate different strategies into their trading plans.

It might also be best to remember that no strategy is perfect; it’s only meant to act as guidelines to assist a trader in their trading decisions.

Below, you’ll find different strategies that could be beneficial for traders to know.

• Scalping: This is a trading strategy used by traders looking to profit from short-term movements in the market potentially. This could be anything from a couple of seconds to minutes. Scalpers, as they’re called, use a variety of technical analysis, price action, and indicators to look for potential opportunities in the market.
• Day trading: This style of trading could also be seen as a short-term strategy. However, instead of a couple of seconds or minutes, day traders are known to keep trades open for a longer period, such as a few minutes to hours. They might also use technical and fundamental analysis, price action, and indicators for potential opportunities.
• Swing trading: This is a medium-term trading style where traders tend to keep trades open for days to weeks. Swing traders aren’t too concerned about price fluctuations daily but more about the long-term trend.
• Position trading: This trading style is a long-term strategy where traders keep their positions open for weeks to months. Some position traders might keep their trades open for years, but these are less common. Traders implementing this strategy again aren’t concerned about daily price fluctuation. Instead, they focus on the long-term trend.
• Price action: This is a strategy that any of the above-mentioned trading styles could implement and forms part of technical analysis. However, it’s more popular amongst scalpers and day traders. Price action focuses on the price movements in the market and making decisions based on that. Some popular price action strategies include candlestick patterns and chart patterns.
• News trading: Traders try to make a potential profit from price movements that are influenced by any major news event, which also forms part of fundamental analysis. An example of a major news event could be the American central bank increasing the dollar's interest rate; this could affect any currency trading against the dollar.
• Trend trading: Trend trading is a more common strategy among swing or position traders, where traders look at the overall trend and potential opportunities to enter and ride the trend. The market trend could be bullish or bearish.
• Breakout trading: Breakout strategies could be incorporated in a shorter or longer-term trading style. With this strategy, the market will most likely be in a period of consolidation, and traders could be looking for a breakout of resistance towards the upside. Or a breakout of support towards the downside to possibly enter a trade. It might be essential to remember that a fake breakout could also take place. This is when a breakout happens; however, instead of the price moving in the way of the breakout, it reverses in the opposite direction. Traders could incorporate other strategies, such as candlestick patterns or moving averages, for further confirmation.
• Hedging: Hedging is a strategy traders use to try and offset any potential losses on their portfolio by opening a position in the opposite direction of their current trade.
• Risk management strategy: This is an essential strategy that a trader might want to incorporate into every trading plan. Proper risk management limits the amount of money a trader could lose per trade. One way of limiting the amount of money a trader could lose is by using a stop-loss order. This order will close the trade automatically once it reaches a certain level established by the trader. There are typically three different types of stop orders traders could use, normal stop-loss, trailing stop, and guaranteed stop-loss.

Forex trading offers various benefits for traders; let’s look at what some of those benefits are:

• Traders can trade a wide variety of different currency pairs.
• The forex market is open 24 hours a day, five days a week. This allows traders to trade any time of the day, no matter where they are in the world.
• Forex trading is a high liquidity market, which means spreads of various currencies are tight, especially on major currency pairs.
• Traders can go long (buy) or short (sell) in the forex market, potentially offering the ability to profit from both rising and falling markets.
• Forex trading is mainly done through derivative products such as spread betting and CFDs. This allows trading through leverage with only a small amount of capital (margin). As mentioned, leverage can magnify profits. However, losses are also magnified.

Now that we’ve reviewed some of the benefits of forex trading, let’s look at the risks involved.

• Traders could experience a margin call. When a trader experiences several losses, and their margin level drops below the required level, they will get a margin call notification, which, if not corrected, the broker can close all their open trades automatically.
• When trading a currency pair in which the interest rate change influences one currency, the effect of this change will be visible in correlated pairs. This is because forex instruments can often correlate, either positively or negatively.
• Prices in financial markets can change quickly, and potential gaps can occur due to market volatility. This is where prices may jump upward or fall downward, creating a gap where there is no trade at the intermediate prices. Stop-loss orders may be executed at undesirable prices when this happens, usually over a weekend or a holiday.
• Leverage is both a benefit and a risk. As mentioned in the benefits section, the reason for this is that it can magnify both potential profits and losses. This means traders could lose more than their initial deposit.

The forex market consists of many currencies trading against each other; the primary way of price movement is determined by supply and demand. However, there are many more factors to consider that will move prices in the market.

Understanding these influences might be crucial in avoiding significant losses to a trader's account.

Let’s look at some important factors that ultimately drive supply and demand within currency pairs.

Political and economic news

Various political and economic news events can determine a currency's strength. Political instability and impaired economic performance can impact the value of a currency.

Politically stable nations with steady and predictable economic performance are typically more desirable to international investors. As a result, these countries attract investment away from countries with more economic unrest. These more desirable investment countries will have a positive effect on their currency.

A political event such as a presidential election will see high price fluctuations.

The scale of economic news events could influence a currency's price on a short or long-term basis depending on the intensity of the news events. It’s safe to say that positive news events could positively affect a currency's value, whereas a negative news event will have the opposite effect.

Different news events could include employment data, manufacturing data, GDP updates, and more.

Interest rates from central banks

A country's central bank determines the supply of a currency. The participation of these central banks will have a significant influence on a currency's exchange rate.

Central banks also determine the interest rate, which can be increased or decreased. The increasing or decreasing of interest rates will have a significant effect on the value of a currency.

Another factor to consider is quantitative easing, where the central banks inject more money into the country’s economy. This can be viewed as a negative event by many forex participants and cause the currency's value to drop.

Foreign debt

A country's debt level could significantly impact the price fluctuations of a currency. Countries with high debt levels compared to their GDP could be seen as less appealing to overseas investors.

These countries that don’t get foreign investments may struggle to increase their financial capital, resulting in greater inflation rates and currency devaluation, particularly if they cannot raise interest rates to compensate.

Market sentiment

Market sentiment is the price movement of a currency; the trend can be bullish, bearish, or neutral. Major market participants will determine the market's direction, usually reacting to news or political events.

Traders might look at how the market moves after such events and make trading decisions accordingly.

Traders can use three charts when trading forex: candlestick, bar, and line charts. Each chart will provide a trader with its own unique information regarding the market and price movements, and traders could implement fundamental and technical analysis accordingly.

Below, you’ll see an in-depth look into each chart mentioned above.

Candlestick chart

Candlestick charts provide traders with sufficient information regarding price movement. Each candle has four key aspects that could be beneficial when reading candlesticks: the high, low, open, and closing price points within a specific time session.

The candle's colour can also indicate how the price is moving, with green or white candles showing the price is bullish and red or black candles meaning the price is bearish.

The different time sessions can be anything from one minute, 30 minutes, four hours, to one day. Let’s say a trader is looking at a four-hour chart; each candlestick will represent four hours of a trading session, while a one-minute chart will have a candlestick represent one minute of trading.

Candlestick patterns and chart patterns are strategies traders could use to read and determine possible future price movements.

Bar chart

A bar chart provides traders the same information as candlestick charts with the high, low, open, and closing prices available. However, each bar is a straight line instead of a coloured candlestick.

The open price in a bar chart will be a small horizontal line to the left, and the closing price will be a small horizontal line to the right. You’ll still be able to see the highest and lowest price points reached during a trading session between the open and closing points.

Line chart

Line charts are the easiest to read because they are simply lines connecting one closing price to the next. A trader won’t be able to see any high, low, or open points for price.

Line charts provide traders with a simplified view of how the market moves, especially for those with a longer-term outlook.

Trading the forex market is easily accessible for anyone with a computer or laptop with a strong internet connection.

Trade nation offers two ways traders can participate in the forex market: through CFDs and spread betting. However, spread betting is only available to residents from the UK and Ireland.

It doesn’t matter if you choose CFDs or spread betting. Trade Nation offers an excellent variety of currency pairs available to trade. 

If you feel ready to dive into the fast-paced world of forex trading, opening an account with us only takes a few minutes.

• To get started, you could sign up by creating an account. This account will serve as a platform to deposit your funds and to keep track of your gains and losses. Moreover, it will give you access to all the necessary tools you could need for trading forex.
• Submit all the necessary documents for your account to be approved.
• After you’ve opened your account and submitted all the necessary documents, it’s time to choose the currency pairs you might want to trade. We offer all the major currencies for you to trade, such as USD, CHF, CAD, AUD, EUR, GBP, and more.
• Next, you might want to look at various strategies you could implement into your trading. You can refer to this article's different trading strategies section for guidance.
• After you’ve picked your currency pairs and trading strategy, you could add the necessary funds to your account.
• Once everything is in place, you could start trading forex through Trade Nation, regulated and authorised by the UK Financial Conduct Authority (FCA), Australia’s Australian Securities and Investments Commission (ASIC), Bahamas Securities Commission of the Bahamas (SCB), Seychelles Financial Services Authority (FSA), and South Africa’s Financial Sector Conduct Authority (FSCA).

*As a side note, trading forex should also be done with caution, and traders should have a solid risk management plan with every trade to limit any potential losses on their trading accounts.