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What Is Forex Trading and How Does it Work?

Matthew Clark
what is forex trading

If equities or bonds don’t excite you as a trader, there is another way to make gains in something called forex trading, or trading in foreign currencies.

Understanding forex trading isn’t difficult. You just need to know the basics and the lingo behind it.

Here, we’ll tell you what forex trading is, how to trade and some of the language used.

That way, you get a better foundation of knowledge before you decide whether forex trading is the right thing for you.

What is Forex Trading?

When you travel overseas, you likely have to exchange your dollars for the home currency of your destination or places you visit. It can be pounds, euros, yen or whatever the locals trade in exchange for goods and services.

That exchange is a forex (foreign exchange) transaction.

Basically, forex trading is buying or selling one currency against its value to another.

The forex market is the most liquid market in the world with an average daily trading volume of $5 trillion. By comparison, Dow Jones Industrial Average trades about $276 million  per day.

Here are the most commonly traded currencies and their abbreviations:

There are others, but those are the most widely traded currencies on the forex market.

Now that you have an understanding of what forex trading is, we’ll get into how you can trade on the forex market.

How to Trade Forex

As with stocks, currency is traded based on what you think the value will be.

Because of the liquidity of the forex market, finding traders to buy or sell is a little easier than with traditional equities markets.

Forex trades are done in pairs because you are betting on the value of one currency against another. And the way you label your currency trade pair is very important.

For example, if you want to trade the euro against the U.S. dollar, your trade will start with EUR and end with USD. If you believe the euro will go up, you will buy EUR/USD. Conversely, if you think the euro will drop against the dollar, you sell EUR/USD.

Think of it as borrowing the first currency in the pair to pay for the second.

Basically, the way it works is you are buying or selling the first currency listed in the pair. When looking at forex prices, you will see a value at the end of the pair. If you see EUR/USD with a price of 1.0997, it means it costs 1.0997 U.S. dollars to buy one euro.

To work it the other way, just divide 1 by the price. In this instance, it’s 0.9093. So, it would cost 0.9093 euros to buy one U.S. dollar.

Here are some of the more commonly traded currency pairs:

You’ll notice the USD is in all of those. That’s because the dollar is the reserve currency in the world. It is the most trusted fallback currency because it has the highest strength compared to others.

The Pip

Gains or losses in the forex market are calculated by pips (point in percentage).

A pip is the fourth decimal place in a currency pair (or the second decimal place when JPY is in the pair).

Let’s say you buy EUR/USD at 1.1000 and you sell it at 1.1050. That’s 50 pips to your favor.

The profit you make, as with stocks, depends on the amount of currency you bought. If you purchased 1,000 units of EUR/USD at 1.1000 each pip is worth $0.10. If you sell EUR/USD later in the day at 1.1050, you have your 50-pip move. Multiply $0.10 (the value of each pip) by 50 and you have a $5 gain.

So the more units you buy, the more your pips are worth. Ten thousand units are considered a mini lot while 100,000 units are a standard lot. Mini lots are valued at $1 per pip. For a standard lot, each pip is worth $10.

The value of each pip can change depending on the currency pair. If USD is the second in the pair, the pip is $0.10. When USD is first, that value changes based on the second currency in the pair. To find the value, all you have to do it divide the pip value of the USD (let’s say for a micro lot, so $0.10) by the current exchange rate between the USD and the second currency in the pair.

So, for USD/EUR, the pip value on a micro lot is worth $0.109. That’s slightly higher than going the other way around (EUR/USD).

It may seem a bit complex, but you can get the hang of it once you understand what forex trading is.

Making Your First Forex Trade

Once you understand the concepts and methodology for trading in forex, you can make your first trade.

But there are some things you need to do first:

  1. Pick the right pair. This is the first step. You understand how the currency pair work (EUR/USD is buying or selling the euro against the dollar, for example). You can pick whatever pair is available.
  2. Check the market. Before pressing send on that first trade, you need to analyze the market. Look at the fundamentals and technical aspects of the currency pair you picked in Step 1. Look for trends, monitor economic announcements and look at your indicators.
  3. Understand the quote. Once you have picked your pair of choice and know whether you are buying or selling, check the quote. On Forex.com, two prices are displayed. The first is the price you can sell the pair while the second is the price you can buy the pair. Every dealer is different, so make sure you check those out.
  4. Decide to buy or sell. One benefit of the forex market is you can speculate the market going up or down. In traditional equities markets, the general speculation is an upward trajectory.
    1. If you are buying, you believe the value of the first currency will go up compared to the second currency. That is taking a bullish position on the first and a bearish position on the second.
    2. If you are selling, it is in reverse. You are speculating the value of the first currency will go down compared to the second.

So there you have the basics surrounding forex trading. We’ve explained what forex trading is, how to trade on the forex market, calculating gains and losses and making that first forex trade.

There are a variety of online forex trading sites that allow you to set up accounts and start trading. Do your research and pick the right one for you.