What is forex trading and how does it work?

The foreign exchange market (forex) is extremely volatile and is constantly fluctuating, affected by external factors such as political changes, and events that take place in the economic calendar. Although risky, trading in currencies can prove to be a worthwhile and lucrative investment. If you undertake extensive research, are patient and understand how to examine and react to the market data, it can be a profitable trading opportunity. 

Getting to grips with the forex market can be challenging, you’ll want to make sure that you fully understand the risks involved and have a well-developed strategy in place before you invest. However, before you do so, you’ll want to know what is forex trading and how does it work and this article will explain just that, to help you to understand what it takes to open a trade in the forex market. 

What is forex trading?

The forex market is one of the most active in the world with almost $6.6 trillion worth of transactions taking place each day. Forex trading is the exchange of national currencies against one another, and the market is open for business 24 hours per day, five days per week. It is believed that trading in currency dates back to 295BC in ancient Egypt, where silver and gold were traded for other lucrative materials. 

Unlike other markets, trade on the forex market takes place over-the-counter (OTC) and electronically, as opposed to having a central marketplace. This makes it possible for trades to be made quickly, in reaction to short-term fluctuations in the market and also enables trades to be made globally, with ease.  

How does forex trading work?

Currencies are traded in pairs, known as currency pairs. The value of one currency therefore is determined by directly comparing it against another. For example, the most commonly traded pair is the euro against the US dollar, which can be identified by its ISO currency code, EUR/USD. If the euro was quoted as 1.2300, this would mean that one euro would enable you to purchase 1.23 dollars. 

Currency pairs are broken down into a base currency and a counter or quote currency. Going back to the previous example, when trading the euro against the dollar, the euro represents the base currency since its value is based upon the value of the dollar. The dollar would therefore be the counter currency in this instance. 

Currency pairs enable traders to evaluate how currencies are moving in accordance with one another. By assessing their movements, investors can make decisions according to their predictions. For example, should the base currency fall against the counter currency, you would most likely take a bearish position, selling your assets. However, if you predict that the base currency will increase in value against the counter, then you would take a bullish position and choose to buy. 

Leverage

On the forex market, traders can utilise leverage in order to acquire a larger position in the market, without having to spend a large portion of their own capital. But how does leverage work? A trader is required to settle the initial margin requirement, which is a fraction of the value of the total trade. The remaining trade value is provided by a forex broker, who would lend the money to you.  

By gaining greater exposure in the market, you access the opportunity to make larger and more profitable trades. However, with greater profit potential comes greater risk and therefore, whilst it is possible for almost anyone to acquire leverage and apply it to their trades, it is vital that you execute extensive market research and have a well-developed strategy before doing so. 

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