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What is Forex Trading and How does it Work

What is Forex Trading and How does it Work

Forex trading is a process of speculating on currency prices. Currencies are traded in pairs, basically a trader is speculating on whether one currency will rise or fall in value against the other.

To understand better what Forex is and how it works, let us introduce to you the main concepts in Forex trading. Here we go!

When to Buy or Sell in Forex

Traders are trying to make a profit by betting on currency's value fluctuations - either it will appreciate or depreciate against another currency. In theory, trader after conducting thorough analysis should be able to assume (with some degree of inaccuracy) tendency (trend) and bet on it.

Forex market runs on the normal business hours of four different parts of the world and their respective time zones, which means trading lasts all day and night ;).

For example, when you hear that the U.S. dollar closed at a certain rate, it simply means that was the rate at market close in New York. That is because currency continues to be traded around the world long after New York's close.

Economic Calendar is a great tool to form an opinion of what might happen, yet using it as a direct call to action is a mistake, often made by inexperienced traders.

Most optimal time to trade Forex is when the market is most active - liquidity and volatility are high.

Forex Trading Times

  • The U.S./London markets overlap (8 a.m. to noon EST) has the heaviest volume of trading and is best for trading opportunities.
  • The Sydney/Tokyo markets overlap (2 a.m. to 4 a.m.) volume of trading is not as high, but it still offers opportunities.

Spread in Forex is the difference between Ask and Bid prices. It varies depending on the market situation, spread is the cost that applies to any trade that you place.

The size of the spread can be influenced by different factors, such as which currency pair you are trading and how volatile it is, the size of your trade and which provider you are using.

  • Fixed spread in Forex - are set by the broker and don't change regardless of market conditions or volatility.
  • Floating spread in Forex - is a constantly changing value between the ask and bid prices. To be precise - the spread you pay for purchasing a currency pair fluctuates which is caused by supply, demand and total trading activity. Floating spread may have a range that is lower than typical when the market is quiet and liquidity is high.

How to calculate Spread in Forex

Formulate the difference between the buy and the sell price in pips. For example, if you’re trading GBP/USD at 1.3009/1.3012, the spread is calculated as 1.3001 – 1.3012, which is 0.0003 (3 pips).

What is pip in Forex

Pip is an acronym for "percentage in point" - standardized unit of change in the price of a trading instrument. 1 pip is calculated by the 4th digit 0.0001.

For example, when the price for EUR/USD currency pair changes from 1.10524 to 1.10515, it means the price has changed in 1.1pips. Smallest move in currency pair can be $0.0001.

To understand how pip is used let's turn to the example, a trader who wants to buy the USD/CAD pair would be purchasing US Dollars and at the same time selling Canadian Dollars.

And vice versa a trader who wants to sell US Dollars would sell the USD/CAD pair, buying Canadian dollars at the same time.

Traders often use the term "pips" to refer to the spread between the bid and ask prices of the currency pair and to indicate how much gain or loss can be realized from a trade.

What is leverage in Forex

What is leverage in Forex - one of the most compelling benefits of Forex trading is leverage.

Leverage is the use of borrowed funds to increase your trading position, apart from what would be available from your cash balance alone.

Brokerage accounts allow the use of leverage through margin trading, where the broker provides the borrowed funds. Forex traders usually use leverage to multiply their profit, especially when there are relatively small price changes.

Important to mention that leverage is a double-edged sword - leverage can amplify both profits as well as losses.

For example - hundred - to - one leverage means that for every $1 you have in your account, you can place a trade worth up to $100. As an example, if you deposited $100, you would be able to trade amounts up to $10,000 on the market.

What is margin in Forex

Margin is the amount of money that a trader needs to put forward in order to open a trade.

The margin required by your Forex broker will determine the maximum leverage you can use in your trading account, that’s why sometimes leverage referred to as "trading on margin".

CFD margins requirements vary depending on broker that is a piece of information worth checking before choosing a broker.

Trading on margin might have potentially big profits as well as losses, you should keep that in the back of your mind when trading on margin.

What moves the Forex market

The Forex market obeys the laws of the market (supply and demand) like any other market.

Let's find out the main influencing factors that drive the Forex market.

  • Central Bank Interest Rates – Either Central bank is raising interest rates, or cutting interest rates and, of course, keeping it on the same level. Reasons behind changing interest rates can be very different.

    For example, when the Central bank is raising interest rates, the general thought is that the economy is growing and they are optimistic about the future, but it could also mean that there is short term strategy in place to boost quick money flow into the budget, etc.

    Traders try to anticipate what the central banks are going to be doing with the rates. If traders expect an interest rate spike, they typically begin buying that currency well before the central bank is scheduled to make the decision, and vice versa.

    If a trader's hunch is wrong, there would be money loss and lots of tears. Thus, they should be well versed in countries' economies of whose currencies they trade on.

  • Trade Flows - measure the net exports and imports of a given country. In reference to currency: when exports are greater than imports, it means possible currency depreciation, this way consumers abroad will perceive the foreign currency to be cheaper. And vice versa.
  • Capital Flows - is the net quantity of currency traded (bought or sold) through capital investments.

    Physical Flows – is when foreign entities sell their local currency and buy foreign currency to make foreign direct investments (f.e. joint ventures, acquisitions, etc.)

    Portfolio investments – is when investments are made on global markets, variable and fixed income market investments (Forex, stocks, T-bills, etc.)

  • Central Bank Intervention - sometimes the value of currency needs intervention, so much so the Central bank feels the need to directly influence the value in its favor, otherwise it could damage the economy.

    For example, when the economy depends on exports, it’s much preferable when the currency of the country doesn't gain too much value. (example in picture smth like this)

  • News - can move the market in very extreme ways. Some news is planned and can be biased towards some investors over others, in this case there is a small chance of overturning the damage, and some news isn’t planned - simply manage risks and hope not getting negatively affected.

    Not all news are market movers, trader has to learn, which one to look for, to be able to make market prediction and draw strategy by extend.

    For example, employment reports from the major financial centers tend to move markets more than a manufacturing sales report, and a retail sales figure riles things up more than a monetary supply report.

    The Economic Calendar (we can anchor link it) is a great resource to help trader determine which reports provide the most punch. Knowing when the markets will move can be one of the greatest advantages trader can have.

  • Greed and Fear - are great amplifiers; fear can turn a falling instrument into an all-out panic and greed can turn a rising market into a blind-buying spree.