Forex Trading - How it Works

February 13th, 2008 | FX Trading Education

Forex Trading

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Forex trading goes under a few different names. Some call it forex, others foreign exchange but for many it is simply FX.

The forex market is the largest and most liquid in the world. About $3 trillion is exchanged every day in this gigantic market which never sleeps, except on Sundays. This 24 hour trading cycle provides its own advantages, most notable of which is the elimination of overnight “price gaps” so commonplace on stock exchanges.

The forex trading market is also unique in that it is not conducted through a central exchange but on the “interbank market”. This essentially means short term borrowing and lending directly between banks on electronic networks all over the globe, rather than through a third party such as a stock exchange.

The main banking centres are Sydney, Tokyo, London, Frankfurt and New York. Since these centres are located around the globe, there is always an overlap where at least two banks are open at the same time. This is what creates the 24 trading cycle.

Different currencies are exchanged as part of the supply and demand for money used to purchase or sell local products. For example, the Australian resource boom in 2007 created a demand for Australian Dollars (AUD) because foreign countries had to pay for these natural resources in that currency. This caused a strengthening of the AUD exchange rate against other major currencies, including the US Dollar.

As one currency is exchanged simultaneously for another, it creates what is called a “cross” rate. This rate is expressed in terms of the value of one currency against the other. For example, if the AUD/USD cross rate is 0.8542 this means that for every one Australian dollar you can only buy 85.42 US cents. The most commonly traded and consequently most liquid currencies are called the “majors”. These are USD/EUR, USD/JPY, USD/CHF and GBP/USD.

The best forex trading market to focus on is called the “Spot Market” because there trades are settled immediately or “on the spot”. Other less liquid forex markets include futures and options markets.

Trading on Margin

If you trade on margin, it means that your capital outlay is only a small percentage of the total value of the assets traded and that someone else finances the balance. The smaller the margin deposit, the greater the remainder that is financed. So if your margin is only 1 percent it means that your dealer or broker is financing the other 99 percent of the trade value. The advantage to you is leverage, but this can also work against you. At 1% margin you can use 1,000 units of your capital to purchase 100,000 units of currency. Your leverage is 100:1 in this case and your returns or losses correspond to the price fluctuation of 100,000 units of currency.

This is why you should not maximise your leverage (reduce your margin) too much. Whilst your profits may be spectacular, your losses could easily be more than your original capital and wipe you out. The percentage of your capital outlayed on any one trade should be a major part of your money management system.

In summary then, these are the major advantages of forex trading over other financial instruments:-

1. 24 hour trading cycle - no price gaps
2. Better liquidity - up to $3trillion exchanged daily
3. No commissions - dealers make their money on the spread
4. Margin and leverage - provided it is used wisely
5. Profit in falling markets - you have the choice how you pair the currencies - e.g. EUR/USD or USD/EUR

Finally, there are a couple of terms to be familiar with. The first is the “spread”. This is the difference between the buying and selling price of one currency, usually called the “Bid” and the “Ask”. The second concept is about “pips”. The “pip” is the smallest unit by which a cross price quote changes. In the case of a major like the US Dollar for example, one pip equals 0.0001 dollar, since the bid and ask prices run out to the 4th decimal place.

Forex brokers and dealers compete by offering tight spreads. You’ll hear offers like “only a 3 pip spread on the majors”.

You can become familiar with the above concepts by opening a free demo account with Forexyard. They provide a “virtual trading” account where you get an imaginary $25,000 and can use it to trade live prices using their state of the art charting program.