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What is Forex Trading and How Does it Work?

Like most things in life, Forex should be approached through careful planning, smart spending, and infinite patience. If it were a culinary dish, Forex would be a crème brûlée: it takes practice, it’s not cheap, and it’s a bit of a wait.

But the results can make it all worthwhile.

Entering the Forex arena without this trading trifecta is relying on pure luck as your trading strategy. So, if you’re thinking about getting your start in Forex trading, you’ll need to have an uncompromising commitment to these principles.

If that’s you, then let’s start at the beginning.

What is Forex Trading?

Foreign exchange, or Forex, is the concept of exchanging one currency for another. It’s that simple.

That doesn’t sound like a very big deal.

Hold on. Remember that time you flew to Norway to accept the Nobel prize for reading long Forex articles, and you exchanged your US dollars for Norwegian krone? That’s foreign exchange. It’s been going on since currency was invented. (In fact, you may have heard of a famous Galilean who once caused a scene by arguing with some money changers – or, as we would call them today, Forex dealers or brokers.)

In modern times, however, the bulk of the volume traded in the Forex market is done by multi-national corporations, central banks, and other large financial institutions.

Today, the Forex market is worth about $2.4 quadrillion, processing over $6 trillion a day in trades.

How do I get a piece of that?

There are a couple of ways to make money in Forex. One is by exploiting interest rate differentials, and one is by profiting from the exchange rate.

Let’s say you exchanged $100 for the equivalent in Japanese yen, and then bought a Japanese government bond. And let’s say that the Japanese interest rate is 6%, and the US interest rate is 2%. The interest rate differential – and your profit – is 4%. However, in an era of permanently low interest rates, the potential opportunities here are very limited.

Alternatively, you can simply buy one currency with another, or sell one currency for another, which is the most common form of Forex trading, where you then convert it back later to complete the trade, hopefully at a profit. For example, you can “bet” that the euro will rise in value against the US dollar and make money when that happens.

Ok, so it’s a legal form of gambling.

Not quite. That’s why I put the word bet in quotes. Guessing the movements of currencies is as surefire a way to lose money as giving it to a stranded Nigerian prince. Traders who are successful in Forex trading get there by conducting careful analyses of the markets and making educated predictions for price movements (but more on that later).

Before we go further, let’s quickly define some basic Forex terms so you’re more in the know (don’t worry, we’ll go through these more in depth throughout the article):

  • Ask – the minimum price for which someone is willing to sell a currency.

  • Bid – the maximum price for which someone is willing to buy a currency.

  • Bear market – when the general outlook is that the currency (or other asset) will fall.

  • Bull market – when the general outlook is that the currency (or other asset) will rise.

  • CFDa Contract for Difference is a way to trade without owning the underlying asset, where you buy or sell the difference between the current price and a later price.

  • Leverage money you borrow from the broker to place trades.

  • Lot size – a lot is a measurement used to trade currency, usually equivalent to 100,000 currency units (mini lots are 10,000 units, and micro lots are 1,000).

  • Margin – the amount of money you keep in your account.

  • Pip – a measurement of price movements, where 1 pip = 0.0001.

  • Spreadthe difference between the bid price and the ask price.

Now I think we’re ready to talk about the Forex market.

What is the Forex Market?

When I talk about the Forex market, I am mainly referring to the trading of international currencies, although the term can loosely include the trading of commodities and stocks as well.

Unlike the stock market, which has a centralized exchange, the Forex market is “over the counter” – meaning that banks and institutions trade currencies with each other, without a centralized and controlled exchange.

People like things that are de-centralized. Just ask Bitcoin brokers.

There are four major Forex trading centers: New York, London, Tokyo, and Sydney. Trading takes place across those four time zones, 5 days a week. This impacts the best time to trade Forex.

All currencies are traded in pairs, expressed in this format: XXX/YYY, where XXX is the currency you’re buying (the “base” currency), and YYY is the currency you’re giving in exchange (the “quote” currency). So, if you’re trading the most popular pair in the Forex market, the EUR/USD, that means that you’re buying 1 euro with US dollars. Similarly, if you’re trading the USD/CAD currency pair, you’re buying 1 Canadian dollar with US dollars.

Here are the major currencies that are traded in the Forex market:

  • As I mentioned, the EUR/USD is the most traded pair, with the euro itself being the second most traded currency, in about 39.7% of trades.

  • The Japanese yen (JPY) is the third most traded currency, in about 25.7% of trades.

  • The British pound (GBP) is the fourth most traded currency, in about 20.7% of trades.

  • The Australian dollar (AUD) is the fifth most traded currency, in about 11.48% of trades.

  • The Canadian dollar (CAD) is the sixth most traded currency, in about 8.0% of trades.

  • The Swiss franc (CHF) is the seventh most traded currency, in about 7.0% of trades.

  • The New Zealand dollar (NZD) is the eighth most traded currency, in about 5.7% of trades.

All those currencies, when traded against the USD, are considered the major pairs.

Here are the minor currency pairs, or “cross pairs,” which do not include the US dollar and are not traded as often as the majors:

  • GBP/CAD — British pound/Canadian dollar

  • EUR/GBP — Euro/British pound

  • GBP/JPY — British pound/Japanese yen

  • NZD/JPY — New Zealand dollar/Japanese yen

  • EUR/JPY – Euro/Japanese yen

  • CHF/JPY — Swiss franc/Japanese yen

  • EUR/AUD — Euro/Australian dollar

Then there are the exotic currency pairs, which consist of emerging market currencies:

  • USD/HKD – US dollar/Hong Kong Dollar

  • EUR/TRY – Euro/Turkish lira

  • GBP/ZAR – British pound/South African rand

  • JPY/NOK – Japanese yen/Norwegian krone

  • AUD/MXN – Australian dollar/Mexican peso

  • NZD/SGD – New Zealand dollar/Singapore dollar

Exotics, of course, are traded even less than the minors.

Got it. Now how do I make my money?

It all comes down to the “bid/ask spread,” which is where the real fun begins.

What is Spread in Forex?

The bid/ask spread (or buy/sell spread) is the difference between the bid price, which is the maximum someone is willing to pay for a currency, and the ask price, which is the minimum someone is willing to accept to sell the currency.

I don’t understand. Give me an example.

Let’s say you…

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