What is forex trading? And How Does It Work?

5:08 PM, May 03, 2023
5:08 PM, May 03, 2023

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What is forex trading? Forex trading, or foreign exchange trading, is a popular way to make money by trading currency pairs in the global marketplace. However, for beginners, the world of forex trading can be intimidating and overwhelming. 

With so many factors affecting currency exchange rates and a complex market to navigate, it can be challenging to know where to start. That's why we've put together this beginner's guide to forex trading. 

In this article, we'll cover the basics of forex trading, including what it is, how it works, and the different trading strategies you can use to start making money in the forex market.

Whether you're a complete newbie or have some experience with trading platforms like PrimeXBT, this guide will provide you with the knowledge and tools you need to get started with forex trading.

What Is Forex Trading?

What is forex trading? Forex trading involves exchanging one currency for another. In this type of trading, a currency pair is always involved, with the trader selling one currency and purchasing another simultaneously.

When trading in foreign exchange, currency pairs are denoted by a three-letter code that comprises two letters representing the region and one letter representing the currency itself. For instance, the US dollar is represented by USD, while JPY stands for the Japanese yen. 

You purchase the US dollar in a USD/JPY pair by selling the Japanese yen. The most commonly traded currency pairs include:

  • The euro versus the US dollar (EUR/USD)
  • The British pound against the euro (GBP/EUR)
  • The British pound versus the US dollar (GBP/USD)

The majority of providers categorize pairs into specific groups to maintain organization.

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Four Types of Forex Pairs:

  • Regional pairs: The grouping of currency pairs based on their geographic location, like Scandinavia or Australasia, is called regional classification. This classification includes currency pairs such as EUR/NOK, AUD/NZD, and AUD/SGD.
  • Major pairs: The global forex trading market is mainly dominated by seven currencies, which collectively account for 80% of the market. These currencies include EUR/USD, USD/JPY, GBP/USD, and USD/CHF.
  • Exotics pairs: The list of currency pairs that involve a major currency paired with a currency from a smaller or developing economy includes USD/PLN, GBP/MXN, and EUR/CZK.
  • Minor pairs: These currency pairs are traded less often and typically involve major currencies paired with each other rather than the US dollar. Examples include EUR/GBP, EUR/CHF, and GBP/JPY.

What is forex trading? Most forex transactions are conducted by banks or people who aim to purchase a currency that will appreciate compared to the currency they are selling. 

Nonetheless, if you have ever exchanged one currency for another, such as when you go on a trip, you have essentially engaged in a forex transaction.

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How Currencies Are Traded

Every currency has a three-letter code, similar to a stock's ticker symbol. Although there are over 170 currencies worldwide, the US dollar dominates forex trading. Therefore, it is essential to know the code for the US dollar, which is USD. 

The euro, which is accepted in 19 countries of the European Union, is the second most popular currency in the forex market, with the code EUR. 

The Swiss franc (CHF), Japanese yen (JPY), New Zealand dollar (NZD), Australian dollar (AUD), British pound (GBP), and Canadian dollar (CAD) are among other major currencies listed in order of popularity.

What is forex trading? In forex trading, the combination of two currencies being exchanged is used to express all trading. The majors, which are the seven currency pairs and account for approximately 75% of forex trading, include


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How Forex Trades Are Quoted

What is forex trading and how are forex trades quoted? Each currency pair represents the exchange rate between two currencies. To illustrate, let's take EUR/USD as an example, which stands for the exchange rate between the euro and the US dollar. It is essential to understand how to interpret this information.

  • The quote currency, the US dollar, is on the right side.
  • If the exchange rate increases, it signifies that the base currency has appreciated compared to the quote currency, resulting in the ability to buy more of the latter with one unit of the former. Conversely, a decrease in the exchange rate indicates that the base currency has depreciated, decreasing its value.
  • The base currency is represented by the currency on the left, which is the euro.
  • The exchange rate measures how much of the quoted currency is required to purchase one unit of the base currency. This means that the base currency is always presented as a single unit. In contrast, the quote currency fluctuates depending on the prevailing market conditions and the amount necessary to purchase one unit of the base currency.
  • The exchange rate of EUR/USD at 1.2 indicates that 1 euro can be purchased for 1.20 US dollars; in other words, it will require 1.20 US dollars to acquire 1 euro.

What is forex trading? It is important to note that currency pairs are typically displayed with the base currency appearing first, followed by the quote currency. In contrast, certain currency pairs have a historical convention for their expression. 

For instance, the conversion of USD to EUR is denoted as EUR/USD and not USD/EUR.

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Bid and Ask Prices

What is forex trading, and how do bid and ask prices fit in? The bid and ask prices are crucial for currency quotes, just like in stock trading. These prices are linked to the base currency but can be perplexing because they show the dealer's position, not yours. 

The bid price is the amount the dealer is willing to pay for the base currency, which means it's the price at which you can sell it. On the other hand, the asking price is the amount the dealer is willing to sell the base currency for, which means it's the price at which you can buy it.

  • The spread refers to the gap between the ask and bid prices.
  • When you sell one unit of the base currency, the bid price indicates the amount of the counter currency you can purchase.
  • In our example, the asking price indicates the amount of USD, also known as the counter currency, needed to purchase one unit of the base currency, which is EUR.

When trading forex, the EUR/USD bid/ask shows the bid and ask prices, with only the last two digits representing the asking price. An example is EUR/USD 1.12044/57, where the bid is 1.12044, and the ask is 1.12057. 

Selling 1€ would fetch $1.12044 (the bid), and buying 1€ would cost $1.12057 (the ask). Brokers usually markup the spread by increasing the asking price and keeping the extra profit rather than charging a set commission. 

The investor benefits from a tighter spread, where the difference between the bid and ask prices is minimal. A pip is a unit for measuring spread, earnings, and losses.

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Three Ways to Trade Forex

What is forex trading, and how does it work? Most forex trades are not conducted to exchange currencies like at a currency exchange while traveling but rather to speculate on future price movements, similar to stock trading. 

Forex traders aim to purchase currencies they believe will appreciate compared to others or dispose of currencies they expect will lose purchasing power. Three forex trading methods are available, catering to traders with different objectives.

  • The futures market. In the same way, traders have the option to choose a uniform agreement to purchase or sell a fixed quantity of currency at a particular exchange rate on a specific future date. This process takes place on an exchange platform, like the best forex desktop trading platforms or best forex mobile trading platforms, instead of being a private transaction, which is typical in the forward market.
  • The spot market. The main forex market is where currency pairs are traded, and exchange rates are determined in real-time, considering the current supply and demand.
  • The forward market. Forex traders can avoid immediate trade execution and instead make a private agreement with another trader to fix an exchange rate for a specific amount of currency on a predetermined future date.

Forex traders commonly use the forward and futures markets to anticipate or protect themselves from potential fluctuations in currency prices. 

These markets base their exchange rates on the present scenario of the spot market, which is the most extensive forex market and where most forex transactions are executed. Traders need to leverage these markets to manage their currency risk effectively.

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What Is Forex Trading? Terms To Know

What is forex trading, and what jargon should you get familiar with? Before participating in forex trading, it is important to familiarize oneself with the specific terminology used within the market, as each market has its unique set of words and phrases.

  • Pip. A pip is an abbreviation for percentage in points, which refers to the smallest price movement possible within a currency pair. This is because forex prices are typically quoted with four decimal places, and a pip represents a change of 0.0001 in the exchange rate.
  • Currency pair. Every forex trade involves two currencies. Apart from the most commonly traded currencies, there are also lesser-known trades, such as exotics which refer to the currencies of emerging nations. 
  • Margin. Due to the size of the lots involved, some traders may be hesitant to invest a large amount of money in executing a trade. To overcome this, traders can use leverage to borrow money to participate in the forex market with a smaller initial investment.
  • Bid-ask spread. Exchange rates, like stocks, are determined by the highest price buyers are willing to pay (the bid) and the lowest price sellers demand (the ask). The difference between these two prices is known as the bid-ask spread, which ultimately determines the value of trades.
  • Leverage. Due to the significant size of the lots, certain traders may be hesitant to invest a considerable amount of money in executing a trade. However, leverage, which refers to borrowing funds, allows traders to participate in the forex market without putting up the full amount of capital needed otherwise.
  • Lot. Exchange rates are influenced by the highest amount buyers are ready to pay for a currency and the lowest amount sellers demand to sell it. The variation between these two amounts, which decides the final executed value of trades, is known as the bid-ask spread.

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What Moves the Forex Market?

Like other financial markets, forex is mainly influenced by supply and demand dynamics. Therefore, it is crucial to comprehend the factors that shape these forces. So, What is forex trading, and what moves it? Keep reading to find out.

Central Banks

What is forex trading, and how do central banks move it? The control of supply lies in the hands of central banks, who have the authority to introduce measures that can significantly impact the value of their currency

One such measure is quantitative easing which involves injecting additional funds into the economy and can lead to a decline in the currency's value.

The central banks determine the base interest rate of an economy. Investing in a currency with a high-interest rate can result in higher returns for investors. 

This can lead to an influx of investors in a country that has recently increased its interest rates, boosting the economy and increasing the currency's value.

However, higher interest rates can also make borrowing one of the best small business loans more difficult. The increased cost of borrowing can make investing more challenging, which may weaken the currency.

News Reports

What is forex trading, and how do news reports move it? Commercial banks and other investors are inclined to invest their capital in economies with a positive outlook. Positive news about a specific region leads to increased investment and demand for the currency of that region. 

A rise in demand without a corresponding increase in supply causes the currency's price to increase, while negative news can lead to a decrease in investment and a decline in the currency's value. 

Therefore, currency prices reflect the country or region's economic status. Checking the economic calendar, particularly on inflation rates, is advisable to determine what lies ahead.

  • Employment
  • GDP
  • Production reports
  • Retail sales

Market Sentiment

What is forex trading? And how does market sentiment move it? The direction of currency prices can be influenced by market sentiment, which is frequently a response to current events. 

Suppose traders perceive that a particular currency is moving in a particular direction. In that case, they may adjust their trading behavior and try to persuade others to do the same, which can impact demand and result in price fluctuations. 

You can find real-time prices, fundamentals, and IG client sentiment on our market data pages for each market.

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Risks of Forex Trading

What is forex trading? And what are the risks involved? Forex trading involves leverage and the use of margins, making it riskier than other types of assets. The prices of currencies are constantly changing but at a minimal rate. Therefore, traders have to make large trades using leverage to generate profits. 

Although leverage can increase gains, it can also amplify losses, sometimes exceeding the initial amount borrowed. In addition, traders who use leverage are exposed to margin calls if the currency's value drops significantly, which may require them to sell their securities at a loss. 

In addition to potential losses, transaction costs can accumulate and reduce the profitability of the trade.

The Securities and Exchange Commission (SEC) warns new traders about potential fraud or confusing information regarding foreign currency trading. This is because individual traders are up against more experienced and skilled professionals in the market. 

However, it may be positive that forex trading is rare among non-professional investors. Only 5.5% of the global market comprises retail traders, and some major online brokers do not offer forex trading. 

Additionally, most retail FX traders struggle to make a profit. Therefore, it is often best to leave forex trading to professionals.

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Why Forex Trading Matters for Average Consumers

What is forex trading, and why does it matter to average consumers? Although the forex market may not suit regular investors, it significantly impacts everyone. The ongoing activities in the spot market influence the prices of exports and the cost of traveling abroad

For instance, if the value of the US dollar increases against the euro, it will be less expensive to purchase imported goods and travel abroad because you can purchase more euros with your US dollars. 

Conversely, importing goods and traveling abroad will be more expensive if the dollar weakens, but exporting companies will benefit. If you plan on buying a costly imported item or traveling overseas, it's a good idea to monitor the exchange rates established by the forex market.

Forex Trading vs. Stock Trading

What is forex trading, and how does it stack up against stock trading? Forex trading and stock trading are not the same, and there are multiple differences between the two:

  • The prices of currencies tend to change quickly, but only by small amounts, which poses a challenge for investors to profit from minor transactions. Consequently, traders use leverage by borrowing money from brokers to trade currencies.
  • In the world of forex trading, transactions happen outside of a centralized exchange, with trades made directly between traders or through the assistance of forex brokers or dealers.
  • The forex market operates non-stop five days a week since traders operate in different time zones.

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What Is Forex Trading? FAQs

We answer similar questions to “what is forex trading?" if you still want to know more.

How Is the Forex Market Regulated?

What is forex trading, and how is it regulated? Although the forex market is massive, it needs more regulation due to the absence of governing authority to monitor it continuously. 

Many national trading entities across the globe supervise domestic forex trading and other markets to ensure all forex providers comply with specific criteria. 

The Commodities Futures Trade Commission (CFTC) and the National Futures Association are the primary agencies responsible for regulating the forex market in the United States.

How Much Money Is Traded on the Forex Market Daily?

The foreign exchange market sees an estimated $5 trillion in daily transactions, with an hourly average of around $220 billion. The market primarily comprises corporations, institutions, governments, and currency speculators. 

Speculative trading accounts for about 90% of the total trading volume, with a significant portion, focused on the Yen, Euro, and US Dollar. 

What Are Gaps in Forex Trading?

A gap in a market refers to a sudden rise or fall in price with no or minimal trading in between. This pattern is less frequent in the forex market than in other markets because forex is open 24 hours a day, five days a week. So, what is forex trading, and when does a gap happen? 

Gapping can occur if unexpected economic news or trading resumes after a weekend or holiday.

Although speculative trading is not allowed over the weekend, central banks and related organizations can still trade. This may cause the opening price on a Monday morning to differ from the closing price on the previous Saturday morning, resulting in a gap.

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How Much Does It Cost To Start Trading Forex?

Regarding forex trading, the cost you'll incur depends on the currency pairs you choose to buy or sell. With IG, you'll be trading forex based on margin, which implies that you'll require only a small percentage of the trade's full value to open and maintain your position.

Although the margin isn't a direct cost, it significantly impacts the affordability of your trade. Besides the margin, you'll also have to pay for the spread, contrasting an asset's "buy" and "sell" prices.

To initiate a long position, you'll have to trade slightly over the market price (buy price) and commence a short position. You'll have to trade slightly below the market price (sell price).

So, what is forex trading, and much does it cost to start? Finally, if you don't close your position before the end of the trading day, you'll be charged overnight funding charges.

When Is the Best Time to Trade the Forex Market?

What is forex trading, and when is the best time to trade? Determining the optimal time to trade forex is contingent upon an individual's risk tolerance, given that forex prices are influenced by high liquidity and volatility

The London session's commencement at 3 am (EST) stimulates traders to initiate interaction, resulting in greater volatility and liquidity. Subsequently, liquidity typically decreases a few hours later, only to be reinvigorated with the onset of the American session around 9:30 am (EST).

The forex market remains operational 24 hours a day and five days a week, starting from 3 am on Sunday and concluding at 5 pm on Friday (EST). 

This allows the traders to trade at any convenient time that suits them and enables them to capitalize on different active trading sessions. Forex market's opening hours may vary when specific nations switch to daylight savings time.

How Do I Open a Forex Trading Account?

What is forex trading, and how do you open a trading acount? To begin forex trading, traders must complete an application process requiring details about their trading experience, knowledge, and intentions. 

Besides, they also need to provide identification proof and fund their account. So, what is forex and how do you set up a trading account? Although the steps may differ depending on the broker, the general process involves these steps.

  1. Visit the broker's website to explore the many available account kinds. They might be modestly sized accounts with low minimum balances suited for novice traders or sophisticated feature-rich accounts for serious traders.
  2. Fill out the application form.
  3. After applying, you will get a username and password, allowing access to your account.
  4. Log in to the client portal for the brokerage.
  5. Set up a bank transfer to deposit money into your account. Checks, credit or debit cards, or an electronic transfer from your bank account are all possible methods. It should be noted that using a credit card, for this reason, may result in interest fees.
  6. You may start trading FX when your account has been funded. Before placing your first transaction, you should carefully read your broker's tips or other information about using their trading platform. Before investing real money in trading, the best Forex traders may practice on a demo account provided by several brokerages.

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Conclusion: What Is Forex Trading

Everyone interested in participating in the international financial market must fully grasp foreign exchange trading basics and finance. Currency trading necessitates being aware of market movements, using a variety of tactics, and exchanging one currency for another.

By getting a firm grip on the essentials and continuing to educate themselves with platforms like PrimeXBT, anybody may take advantage of the many possibilities the foreign exchange market offers.

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