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What is Forex Trading and How Does It Work?

FX Scouts By Jeffrey Cammack Updated: September 24, 2019
What is Forex trading?
Source: Getty Images

Forex trading is a form of OTC (over the counter) CFD (contract for difference) trading that involves speculating on the future value of currency pairs.  A Forex trader will identify a currency that they believe will change in value in the near term, and then open a trade which states the direction they suppose the value of that currency will move in. 

After a period of time, the trader will close the trade for a profit or a loss, dependent on if the trader was correct in their thought.  In CFD trading, since it is purely speculative, a trader can profit from the decreasing value of a currency.

Because large amounts of capital are needed to make real profits from minute exchange rate fluctuations, Forex trading has historically been reserved for institutional investors and global banks.  It is now regulated by the Australian Securities and Investments Commission (ASIC) in Australia and other major regulators around the world.

However, with the advent of online trading and the introduction of leveraged trading, the Forex market is now accessible to anyone with a few hundred dollars and a computer. There are now millions of retail Forex traders all over the world, and it is a major investing mechanism for Australians.

How does Forex Trading work?

Before starting to trade (opening a position) a trader needs to decide.

  • Which currency pair to trade
  • The amount to invest in the trade
  • How much leverage to use in the trade
  • The direction of the trade

Currency Pairs

Currencies are always quoted in pairs because as you are selling (give away) one currency, you are buying (take ownership) another one simultaneously.  This is normal behaviour for any purchase, as we give away money to take ownership of new products all the time.  Only in this case, we are exchanging one currency for another. 

In Forex trading, the first currency in the pair is called the base currency, while the second currency in the pair is called quote currency.

Currency pairs are split into three groups based on how much market liquidity exists.  The more investors who are actively participating in trading a currency pair, the more liquidity will be exhibited.

The Major Pairs

The major currency pairs are most commonly traded because they are the most volatile and they are highly liquid.  The major pairs all include the USD as part of the pair.

  • EUR/USD – Euro / United States Dollar
  • GBP/USD – British Pound Sterling / United States Dollar
  • USD/CHF – United States Dollar / Swiss Franc
  • USD/JPY – United States Dollar / Japanese Yen
  • AUD/USD – Australian Dollar / United States Dollar
  • USD/CAD – United States Dollar / Canadian Dollar
  • NZD/USD – New Zealand Dollar / United States Dollar

The Minor Pairs

The minor currency pairs are not a fixed list like the majors.  They are generally currency pairs that do not include the USD.  Some examples might be:

  • EUR/JPY – Euro / Japanese Yen
  • GBP/AUD – British Pound / Australian Dollar
  • AUD/NZD – Australian Dollar / New Zealand Dollar

The Exotic Pairs

The final group are called exotics and are generally pairs containing currencies from a well-developed economy and a developing economy.  Examples could be:

  • EUR/BRL – Euro / Brazilian Real
  • GBP/ZAR – British Pound / South African Rand
  • AUD/MYR – Australian Dollar / Malaysian Ringgit

Trade Size

The size of a trade is the amount of capital invested in a single trade.  Risk management tells us that trade size should always be connected to relative certainty of winning the trade, and basic trading guidelines.  

As a rule of thumb, traders should never risk more than 2% of their capital in a single trade.  If a trader has an account balance of 500 AUD, then never risk more than 500 AUD x 0.02 = 10 AUD in a single trade.

While it is tempting for novice traders to think of trade size in Dollar amounts, experienced traders will advise considering trade size as a percentage of your account balance.

Leverage in Forex Trading

Forex and other CFDs are leveraged products.  To generate larger profits from trading Forex, traders will borrow money to invest using a mechanism called leverage, as the movements in the Forex market are too small to make a significant profit from with a small account balance.

Leverage is either offered by your broker or more commonly through a third-party liquidity provider. Depending on the broker, the country of residence and the experience of the trader, some brokers can make more leverage available.  

While leverage can amplify profits, it will also amplify losses.  In a leveraged trade, the capital borrowed must be returned after the trade is closed.  If the trade is closed at a loss, the remainder of the lost funds will be collected from the trader’s account balance.

High levels of leverage are the primary reason for large losses by retail traders.  A June 2018 study by ASIC showed that “63% of clients who trade CFD over currency pairs lose money” and promoted further investigations into leverage by the regulator.  It also noted that “Complex product features, such as the high leverage offered in CFDs—as high as 500-to-1 for foreign exchange CFDs—or the high likelihood of cumulative losses inherent in binary options, have contributed to retail clients’ financial losses and can often be misaligned with their needs, expectations and understanding“.

Following these findings, ASIC released a Product intervention: OTC binary options and CFDs in August 2019, which has will “impose conditions on the issue and distribution of OTC CFDs to retail clients including imposing leverage limits“.  Further information is expected in October 2019, but the likely outcome will be a restriction in leverage offered to retail traders who have not applied for professional status.

Trade Direction

When opening a position, the trader needs to make a decision on which way they believe the value of the currency pair will move.  Should the trader believe that the value of the base currency (the first currency in the pair) is going to rise, they will place a long trade.  If they believe that the value of the base currency will fall, they will place a short trade.  

In this example, the trader goes long, expecting the value of the USD to increase.

In this example, the trader goes short, expecting the value of the USD to fall.

As it happened, the USD increased in value, and the USD/AUD gained 9 pips during the time I was monitoring it.  So had the trader gone long and bought USDAUD, they would have made a profit relative to the size of their investment.

Forex Trading Examples

Here are two trading examples, both with the USDAUD pair, where one is a long trade, and the other is a short trade.

How to Calculate Profits

The profit of a trade is calculated as the change in price, multiplied by the closing price, multiplied by the size of the trade (in units)

Long Trade Example

A trader buys one standard lot (100,000 of the base currency) of USDAUD and opens a long trade at 0.7858 with the expectation that the value of the pair will increase.  After some time, the value of USDAUD increases as expected to 0.7879 so the trader closes the position.

Since the trader predicted the market correctly and sold at a higher price, the trade is closed with a profit of 210 AUD.

Short Trade Example

If it is assumed that that USDAUD was going to weaken, a short position should be opened. If we were to open the short position on the same trade, entering at 0.7858, and the value of USDAUD drops to 0.7818 then the profit would be 400 AUD.

Note:  If you are going short, and the profit in your calculation is a negative number, that is a positive result on your account.  Read more on what is A Stop-Loss and Take-Profit?.

Quotes and Spreads

The majority of Forex brokers largely make their money through the differences between the buy and sell prices in a currency pair. The difference between these two prices is called the spread and is measured in pips.

Example spread: AUD/USD is 4 pips

While market maker brokers or instant execution account types will have fixed spreads, direct market access (DMA) brokers will have variable spreads dependent on the liquidity available at the time of opening the trade.

How can I trade Forex successfully?

To be successful, you will need to learn the basics of trading, invest time into doing analysis and stay up-to-date with international news events.  You will also need to cultivate your self-discipline.  Trading successfully is difficult, and it requires focus and a strategy.

There are three main strategies for analysis in trading:

  1. Trading the fundamentals – trade based on analysis of news events that affect markets. An excellent example of this would be trading the Non-Farm Payroll Report from the USA or trading the COT Report.
  2. Trading the technical charts – trading by following charts and trading the patterns.  If you are going to be a technical trader, you should understand trends and momentum in the market, as well as pivot points where the market makes a sudden turn.
  3. Trading the market sentiment – Trading by watching what the traders and banks are doing, and following them or going against them.

How much money can I make from Forex trading?

Some traders make money trading Forex, but 70-90% of retail traders lose money.  How much you can make trading Forex depends on the amount you are trading with, the amount of time you spend trading and your appetite for risk.  Should you break even trading Forex, you are doing a lot better than most other traders.

How to get started

Beginners should always start with a demo account.  A demo account is a play-money account with real market data where novice traders can practice in a hands-on environment.  Beginner traders should also start by learning some of the basic strategies of Forex trading, and studying examples of trades.  Regardless of if the trader is opening a demo or a live account, the trader will need to identify a Forex broker with which to open an account.

To start trading, you need to sign up with the Forex broker of your choice.  When picking a broker you will need to look at the minimum deposit expected, the leverage available to traders, the minimum spread, and the regulation.  Together, these will help you determine the right broker for you.

When you visit a broker from our website, you will go to the account sign up page.  After completing your details, the broker may call to introduce themselves and see if they can answer any questions for you.  They will also use this opportunity to explain a process called KYC or “Know Your Customer” that is a requirement for broker working with clients to protect them and you from money laundering activities.

To complete your KYC requirements, you need to provide copies of a national identity document and also a utility bill or proof of residence.  As soon as these documents are completed, you will be able to make your first deposit and start trading.

How much money do I need to start trading Forex?

Some Forex brokers will let you start trading with as little as 5 AUD in your account.  A deposit of at least 200 AUD is recommended because your balance needs to be able to cover any temporary losses on your account, which may not be possible with a smaller balance. 

In addition, if you are planning on using leverage in your trades, the account balance will be used as collateral.  If you don’t have ample funds in your account protect against the full amount of any potential loss, the broker will close your trade early in what is called a margin call.

Global Forex Brokers

The Risk in Forex Trading

Trading CFDs comes with significant risk, and if you are concerned about losing any the money that you are depositing, then don’t trade Forex.  Forex trading is not a get rich quick scheme and requires dedication and study.

As a trader, you will need to develop a trading plan, understand risk management, and have a goal with what you want to achieve.  Don’t start depositing money until you are sure you want to give this a good shot. Every trader loses trades that they were sure they would win, so expect the unexpected and have a plan for when your trades fail.

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.