How does Forex Trading Work?

What is Forex Trading?

Forex trading is a form of CFD trading which is different from other types of trading in two significant ways. CFD trading is speculation on the value of an asset, where the trader does not take ownership of the asset itself. Also, because it is speculation on the value of the asset, the trader can make money by speculating on either the increasing or decreasing value of the asset.

How Does Forex Trading Work?

A Forex trade has four main components – the asset in the trade, the size of the trade, the value of the trade, and the direction the trader believes the value will move in. Each of these is unique and affects the profitability of the trade.

The Asset – Currency Pairs

In Forex trading, the asset is always a set of two currencies called a currency pair. Currencies are quoted in pairs, as two currencies are bought and sold simultaneously. A typical currency pair is the EUR/USD (Euro/US dollar).

The first currency of any currency pair is called the base currency and the second currency is called the quote currency. In the EUR/USD (EURO/US Dollar) currency pair the EUR, the base currency and the USD is the quote currency.

The Value – Forex Quotes

The value of a currency pair is called a Quote. As currencies are quoted in pairs, the value of the quote currency is set in relation to the base currency.

As an example, let’s continue with the EUR/USD currency pair. The currencies in the EUR/USD pair are quoted at 1.1332, meaning that 1 Euro can be exchanged for 1.1332 US Dollars. In currency trading, the changes in the value of one currency against another are what generates the profit or the loss.

Value is calculated in Pips

In Forex trading, the value is measured in Pips. A Pip is the smallest possible change in the value of a currency pair, and measured on the 4th decimal place.

If the EUR/USD pair that was quoted at 1.1332 increased in value by one Pip the new EUR/USD quote will be 1.1333

Calculate It Yourself!
To calculate your profit in pips, use the following equation. Profit in Pips = Change of Value in PipsSpread in Pips.

What is Forex Quotes and Spreads?

The value of a currency pair is quoted using a two-price quotation system – a price for buying and another for selling, where the pricing is set from the Forex Broker perspective, whereas the difference between the two is called the Spread.

In general the broker will Ask (sell) for a higher price than what they will Bid (buy) a currency pair for.

  • Bid = the price the broker is willing to buy the currency pair.
  • Ask = the price broker will sell the pair for.

The spread is measured in pips and will tell you how much your broker will charge in commission for buying and selling the pair. The Spread is typically different for each currency pair.

The EUR/USD currency pair Quote has:

  • Bid at 1.1332
  • Ask at 1.1333; which is one Pip more, thus the Spread is 1 PIP.

To make a profit on the trade, a trader first needs to overcome the cost of the spread. So, assuming you are trading one standard lot, you need to earn 20 USD on your trade, to make 10 USD, as 10 USD will go to the spread. This means the Ask price needs to move two pips in your favour to 1.1333.

The Size – Forex Lots

In Forex trading the size, or volume, of a trade is measured in Lots. This is similar to how stocks (equities) are measured in shares, and gold is measured in ounces. Forex trading platforms use a Lot as a unit of the volume. Together, the Lots volume and the Quote for the currency pair will determine the total monetary value of the trade.

A Lot represents a standardised quantity of a currency pair, whereas;

  • 1 Standard Lot is 100.000 units.
  • 1 Mini Lot is 10.000 units.
  • 1 Micro Lot is 1.000 units.

Example; trading one Standard Lot EUR/USD quoted at exchange rate 1.1332 (1 EUR give you 1.1332 USD):
1 Lot = 100.000 X 1.1332
1 Lot = 113.320 USD

If the EUR/USD Quote move from 1.1332 to 1.1333; a 0.0001 increase = 1 Pip, we can calculate our Pip value:

Pip value = 1 PIP X 1 Lot
Pip Value = 0.0001 X 100.000
Pip Value = 10 USD

Our profit above equals to 10 USD.

Leverage Amplifies Volume

Leverage is used in forex trading as a multiplier of the size of your trade.

All CFDs are considered leveraged products, which enables the trader to make more significant trades than their account balance allows, by borrowing additional funds via the brokerage or a connected 3rd party. While this can increase profits dramatically, the trader is responsible for any eventual losses on the full trading amount. As such, using high amounts of leverage can cause significant losses.

Taking a EUR/USD trade with 1:100 leverage which equals to 1% of a Standard Lot requires a margin of:

Margin = 1% X 1 Lot
Margin = 0.01 X 113.320
Margin = 1.133,2 USD

To trade 1 Lot EUR/USD which is worth 113.320 USD, we need to have 1.133,2 USD in our trading account.

IMPORTANT: Using leveraged products mean that you as a trader take on a loan!
In the example above you are paying a deposit of 1.133,2 USD to borrow 112.187 USD to make the trade. This is similar to the down payment when buying a house where you take a bond at your bank.

The Direction – Long or Short

In Forex trading you speculate on whether a currency pair will increase or decrease in value (direction). A trader can make a profit from any trade, provided they speculate correctly on the direction the value of the currency pair will move in.

Turning a profit from a decreasing value of an asset is unique to CFD and Forex trading.

Long is the term used for buying, where the trader buys the base currency while selling the quote currency. A profit would be made should the value of the base currency increase.

Short is the term for selling, where the trader sells the base currency while buying the quote currency. In this case, the trader would turn a profit should the value of the base currency drop against the quote currency.

Forex Trading Example – Trading 1 standard lot EUR/USD

The EUR/USD currency pair is trading at 1.1332. The Ask price (buy) is at 1.1333 and the Bid price (sell) is at 1.1331. You are speculating that the Euro will increase in value against the US Dollar and place an order to buy 1 standard lot at 1.1333. By placing the order, you enter a trading position of 100.000 EUR equivalent to 113.330 USD, as one standard Lot EUR/USD is 100.000 units.

You decide to trade with 1:100 leverage which mean that you will not have to pay the full value of 100.000 EUR upfront. This mean that you can enter the trade by committing 1% as margin which equals to 1.000 EUR.

If your trade is correct

The Euro strengthens against the US Dollar and is now trading at 1.1374 and you decide to close your trade. The Bid price (sell) is at 1.1373.

Your 100.000 EUR now equals 113.730 USD. This mean that you have earned 113.730 – 113.330 = 400 USD profit on your trade.

If your trade goes wrong

The Euro weakens against the US Dollar and falls to 1.1277. The Bid price (sell) is at 1.1276.

This mean that you lost 570 USD on your trade, as your 100.000 EUR is now worth 112.760 USD (112.760 – 113.330 = -570 USD).

Find a Forex Broker

Forex trading starts with the choice of a broker to execute trades on the Foreign exchange market. Forex brokers each offer traders different trading conditions and are regulated in various governments. In the list below, we compare brokers by the minimum spread measured in pips and the maximum leverage offered by the broker. There are other considerations when comparing brokers such as regulation and minimum deposits required to open accounts.

If you are inexperienced in Forex Trading we strongly recommend starting out trading with a Forex Demo account! Demo accounts are a good way for a new trader to learn forex trading without risking any capital.

What’s Next?

This article is a very high-level overview of how to trade forex on the international markets. You have learned some of the basic language terms, you know what a currency pair is, and you have read some tips and strategy to get you started.

Expect learning to trade Forex profitably to take time and dedication. A trader needs to learn how to operate the software, do analysis, and manage the risk in the account. There is an education section to continue reading and explore many of the principles to succeed in trading. Here are articles most relevant to getting a good start at Forex trading.

Jeffrey Cammack Administrator
Editorial Director at TradeForexSA
Jeff Cammack is the Editorial Director, a Forex trader since 2008, and educator. Always in search of new trading opportunities, Jeff can always be found doing research in the charts or combing through the financial news. When not trading, he is always researching his next article.
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Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
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