Forex trading is a speculative investment vehicle which involves trading two currencies against each other in order to benefit from the difference in the exchange rates that exist between both currencies over time.
What produces the profit opportunity is the fact that the pricing or exchange rate for which you can exchange one currency with another, is subject to change according to forces of demand and supply. The rates go up and down. Therefore, you can profit if you buy or if you sell, as long as you follow the direction of the exchange rate changes.
Currencies are assets, and all assets are sold in a marketplace. However, the forex market has no physical location. Rather, the forex market is a multi-tier virtual market whose location is the online-linked computers of the major banks (liquidity providers) that constitute the interbank FX market. This level is also where the central banks (the government organizations that print money and control monetary policy) operate.
Other tiers of the market are made up of banks, institutional traders, hedge funds, prime brokers and retail brokers (market makers). These acquire pricing and conduct trade executions from the liquidity providers. Bringing up the rear are the retail forex traders, whose orders and executions are handled by the retail FX brokers as well as the ECN/STP brokers.
Thus the forex market is decentralized as there is no physical location. All participants at some level are connected to the market using their trading platforms, which have a front-end (customer/trader end of the chain) and a back end solution.
Online forex trading has the following characteristics:
Unlike stocks and other traded assets which are traded on their own, currencies are always traded in pairs. This is because the rate of exchange of a currency does not fluctuate in isolation but has to be compared with another currency. For instance, you can use 1 Euro to purchase a certain amount of US Dollars at a specific rate, but a short while later, you can either re-exchange the US Dollars earlier acquired for more or less Euros than initially used in the transaction. So currency trading is all about comparing one currency with another, and determining the difference in the rates of exchange between two selected currencies after a time difference.
There are more than 100 currency pairs in the market, and they are divided into major, minor and exotic currencies.
When currency pairs are written, they are written like this: EURUSD or EUR/USD, CADJPY or CAD/JPY, etc. The 3-letter currency abbreviation on the left is called the base currency and is always expressed as 1 unit. The 3-letter currency abbreviation on the right is called the counter currency and is expressed as the price seen in the price quotes. The relationship between the price, base currency and counter currency will be explained shortly. But what are the currency abbreviations?
Currencies are abbreviated with three letters. The first two letters feature the name of the country where the currency originates. The last letter is taken from the currency name, with majority being the first letter of the currency.
You can get a full list of currency pairs and abbreviations from the search engines.
Every forex pair has two prices listed in a price quote. These are the bid price and the ask price. The bid price is the price stated on the left of the quote, while the ask price is stated on the right. The difference between the two prices is known as the spread; this is the broker’s compensation and is deducted immediately a trade order is executed.
A price quote for EUR/USD could be listed as 1.01015/1.01022. The pricing system for currencies was changed a few years ago from a 4-digit to a 5-digit decimal system to provide for more accurate pricing. The 5th digit is a tenth of the 4th digit. So in this price quote, the spread of the asset is not 70 pips but 7.0 pips.
The bid price is the price at which a sell order is executed, while the ask price is the price at which a trader’s buy order is executed.
Prices are always quoted in terms of the number of units of the counter currency (currency on the right of a pair) that can be bought or sold for one unit of the base currency (currency on the left).
So if we quote the EURUSD as 1.11089/1.11092, it means that 1 Euro can purchase 1.11092 US Dollars, or be sold for 1.11089 US Dollars.
So the price on the left of a price quote, is the number of units of the counter currency (on the right) that 1 unit of the currency on the left (base currency) can be sold for.
The price on the right of the quote (the ask price) is the number of units of the counter currency that 1 unit of the base currency can buy.
You can make money in forex trading by either buying a currency you fell will increase in value relative to another, or you sell a currency that you expect to drop in value relative to another currency. These are known as long (buy) or short (sell) orders.
There are several types of trade orders. You can use a market order (market buy, market sell) to go long or short at the current price of the forex pair.
A pending order (buy limit, sell limit, buy stop, sell stop) are used to go long or short at prices that are different from the market price.
You can set the trade volume (lot size) or leverage for a trade. The reference size is the Standard Lot, which is equivalent to a lot size of 1.0 and a volume of 100,000 units of your account currency. This trade size is subdivided into mini-lots and micro-lots. 1 mini-lot is 10,000 units, and 1 micro-lot is 1000 trade units. Further divisions are derived from these numbers.
You need a forex trading account to trade. Your broker will provide it for you when you register for an account on their website. You will need your government-issued IDs for verification, access to a payment channel and trading capital. It’s very easy to obtain a forex account from any of the brokers listed on the website.