How does Forex Trading Work?

Forex trading is the buying and selling of currency pairs.  For example, a forex trader would sell USD (US Dollars) and buy ZAR (South African Rand) with the hopes that the value of the ZAR increases. When the value of the ZAR increases, the trader sells the ZAR currency making a profit.  Forex trading is done using a Forex broker on the Internet as they will be your link to the International money markets.

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In Forex trading currencies are traded in pairs

Currencies are quoted in pairs with each currency taking a 3 letter abbreviation.  Some of the most commonly traded currencies are:

  • USD – United States Dollar
  • EUR – European Union Euro
  • GBP – Great Britain Pound

Forex Quotes

Forex quotes are made up of a base currency and a quote currency.  This is the price you can buy and sell a unit of the currency for.

  • Base currency is the currency you are buying when you trade the forex pair
  • Quote currency is the currency you are selling when you trade the forex pair.

As an example, if the USD/ZAR is quoted at 14.10, to buy $1 you need to pay R14.10.

Bid price (buy) and Ask price (Sell) of currency pairs

A currency quote contains two prices. The forex market uses a two-price quotation system that includes two prices – one for buying and one for selling:

  • Bid price is the maximum price any buyer is willing to pay for the currency
  • Ask price is the minimum price any seller is willing accept for the currency

The Spread in Forex Trading

The “Spread” is the difference between the bid- and ask price value of the currency pair.

What is a PIP in Forex Trading

The term Pip is an abbreviation of Percentage in Point and is the smallest possible movement in the value between two currencies (a currency pair).

A currency is valued in 4 decimal places, apart from the Japanese Yen (JPY) that uses two decimal places, whereas the Pip is the smallest incremental movement between two currencies in the pair.  Learn more about pips here

Example: In the case of the EUR/USD, a change in the value of the currency pair of 0.0001 would be measured as 1 pip, and a change of 0.01 in the EUR/JPY pair would be measured as 1 pip.

Leverage & Margin in Forex Trading

Because the movements on the currency market, traders need a way to magnify the size of trades.  Leverage is used to do this, and it is found in all forms of CFD trading.  Leverage is offered through your forex broker, and if often provided by a third party like a bank.  This means that with a very little money, you can make big trades, by only putting up a deposit to protect against the loss.

The deposit to protect against the loss is called Margin.  Once a trader has decided on the currency pair they want to trade and the size of the investment, we need to make sure we have the margin available in the account.  If the margin is not available, the broker will not allow us to open the trade.

How to get started?

Before you are able to trade forex, you need to sign up with a forex broker as they are the way that you access the international forex market.  Each broker has their pros and cons, but each of the reputable brokers that we have featured on this site will be able to get you started with either webinar content or with an experienced trader to introduce you to some of the below concepts

Trading on Mobile Phones & Apps

Traders often like to use mobile devices while away from desktop computers or tablets.  There are advantages to trading with a broker which as a good mobile application available to you, but I would discourage trading solely on a mobile device – simply because of screen size and how much better it can be to research on a bigger screen.

I often use a mobile device for monitoring ongoing trades, and entering into trades should I be away from a computer when significant news events happen.  To read more about the features of forex trading apps read our article here.

Next Steps And Recommended Material

There is a way to learn to trade Forex risk-free by using an account called a demo account.  A demo account can be useful for a number of reasons:

  • You don’t have to deposit money – you never have to deposit money to be able to get a demo account.  The way it works is that a broker will load an account with play money that you can use in their brokerage, on their software, and with the live market data.  This is the best way to learn because it is risk-free and you never will lose money you can not afford to lose.  Interested in reading more – here is our article on the best brokers for demo accounts.
  • You can practice doing market analysis – if you are going to be a successful trader you will need to learn how to analyze charts (technical analysis) and also understand how news events can affect the markets (fundamental analysis). A demo account will allow you to practice your trading based on these two analysis types.  Read more here about the difference between fundamental analysis and technical analysis.
  • You can try the software used in trading – different brokers will have their own software that allows traders to use special tools and functionalities specific to that brokerage.  An example would be how eToro has social trading and needs a web browser to give clients access to those features.  Using a demo account would allow you either to try the software the brokers offer or learn to set up and use MetaTrader 4 which we have a guide about.
  • You can see if you think trading is fun – trading needs to be fun for you because you will need to be diligent and treat it as your job.  This is a good way to find out if you have that interest and dedication.

Main Strategies for Successful Forex Trading

1.  Above all, learn the language of trading.  Before you are able to learn the basics of strategies you will need to understand what a Pip is, what a pivot point is, and what a gap is.  These are just some examples of language used, but if as you read you will learn the meanings of this new terminology.

2.  Are you certain enough that you are making the right call, and that you are putting the right amount of money into the trade?  This all comes down to money and risk management and knowing where your currency reserves are.  A general rule is not to trade more than 2-3% of your capital in a single trade and develop a trading plan.

3.  Have you, or the market, seen these market conditions before?  History always repeats itself.  You should always be taking notes on the success and failure of your trades so that you can use this analysis to help guide you in the future.  As an example, we have published a historical analysis of the EURUSD pair that shows this effect.

4.  You need a target for any trade – know your exit strategy.  Whatever strategy you are about to implement, you need to have a target value.  This helps remove the emotion from the trade as well, making it easier to act with a clear mind.

5.  When are you going to enter the trade?  Analyze your trade by using charts, or by reading the news and following the economic events of the day.  This is technical vs. fundamental analysis and each has their place.  Never rush your trades only to make a trade, but instead time them right, and use a strategy that works to your advantage.

This is a very high-level overview of how to trade forex on the international markets.  We have a full education section to get you started, but these are some core strategy questions and a collection of basic strategies that you could consider when looking for a currency pair to trade.

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.