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The exchange of foreign currencies, commonly known as forex trading or FX, is a global market that involves buying and selling currencies. Today, there are many exchanges where you can trade currencies, like our top pick Prime XBT.So what is forex trading, and how can I get involved? Today, foreign currency exchange is the biggest market in the world. Its transactions have an impact on many aspects of your daily life, including the cost of goods imported from China and the price of a margarita when holidaying in Mexico.
What Is Forex Trading?
Forex trading involves exchanging one currency for another. In this type of trading, you always buy one currency while selling another currency simultaneously, as it involves trading in currency pairs.
To understand what is forex trading, you should get familiar with currency pairs. Each currency in a pair is identified with a three-letter code consisting of two letters indicating the region and one for the currency itself.
For instance, USD refers to the US dollar, and JPY stands for the Japanese yen. Put together, they make a currency trading pair. In the case of USD/JPY, purchasing the former means selling the latter.
The currency pairings that are traded the most often are the euro against the US dollar (EUR/USD), the British pound against the euro (GBP/EUR), and the British pound against the US dollar (GBP/USD).
Most suppliers divide pairings to make up what is forex trading today into the following groups to maintain order:
Four Types of Forex Pairs:
- Major pairs - There are seven currencies that make up 80% of the foreign exchange market. These include EUR/USD, USD/JPY, USD/CHF, and GBP/USD.
- Minor pairs - Major currencies are usually paired with each other instead of the US dollar in less frequent trading. This includes EUR/CHF, GBP/JPY, and USD/GBP.
- Exotics pairs - This type includes a significant currency against a currency from a developing or minor nation. This consists of USD/PLN, GBP/MXN, and EUR/CZK.
- Regional pairs - Regional pairings are arranged geographically, like Scandinavia or Australasia. Examples of this include EUR/NOK, AUD/SGD, and AUD/NZD.
The majority of forex trades are conducted by banks or individuals who aim to purchase a currency that is expected to appreciate in value against the currency they are selling. Nevertheless, if you have ever exchanged one currency for another, such as during a trip, then you have participated in a forex transaction.
What Is Forex Trading: How Currencies Are Traded
To answer the question, “What is forex trading," we must first understand the currency trade. Every currency in the world is given a three-letter code similar to the ticker symbol of a stock. Although there are over 170 currencies globally, the U.S. dollar dominates forex trading, which makes it crucial to be aware of its code: USD.
EUR is the code for the euro, which is the second most commonly traded currency in the forex market and is accepted in 19 European Union countries.
The Swiss franc (CHF), Japanese yen (JPY), Australian dollar (AUD), New Zealand dollar (NZD) British pound (GBP), and Canadian dollar (CAD) are the other major currencies in descending order of popularity. The best forex trading platform can help make these options clear.
In the forex market, currency trading involves a combination of two currencies. The major currency pairs, which refer to seven specific pairs, make up approximately 75% of the total forex trading. They include:
What Is Forex Trading: How Forex Trades Are Quoted
Currency pairs are used to indicate the relative exchange rate of two different currencies. To illustrate this, let's take the example of EUR/USD, which stands for the exchange rate between the euro and the US dollar:
- The base currency is the euro, which is shown on the left of the pair.
- The quotation currency is represented by the U.S. dollar on the right.
- A unit of the base currency may be purchased with a certain amount of the quote currency, which is represented by the exchange rate. As a consequence, the quotation currency fluctuates depending on the market and how much is required to purchase 1 unit of the base currency. The basic currency is always stated as 1 unit.
- A rate of 1.2 between the Euro and the US Dollar indicates that one euro can be purchased for 1.20 US dollars.
- When the exchange rate rises and one euro can buy more U.S. dollars, it suggests that the base currency has strengthened in comparison to the quoted currency. Conversely, if the exchange rate drops, it means that the base currency has weakened.
To understand what is forex trading, it is important to note that currency pairs are typically shown with the base currency listed first, followed by the quoted currency, with some exceptions based on historical convention. For instance, USD to EUR conversions is denoted as EUR/USD, not as USD/EUR.
What Is Forex Trading: Bid and Ask Prices
The bid price refers to the amount which the dealer is willing to pay to purchase the base currency from you, while the asking price is the value at which the dealer is ready to sell the base currency to you. These are key aspects to understand to answer the question, “What is forex trading?"
In short, the bid price is the cost at which you can sell, and the ask price is the cost at which you can purchase the base currency. Here is an example of how it works:
- The ask price indicates the amount of the counter currency (in our example, USD) that is required to purchase a single unit of the base currency (EUR).
- When you sell one unit of the base currency, the bid price indicates the amount of the counter currency that you can purchase.
- The spread refers to the gap between the ask price and the bid price. It is essential to include both prices while calculating the spread.
The representation of the bid and ask in EUR/USD bid/ask format includes only the last two digits of the ask. In EUR/USD 1.12044/57, the bid is 1.12044, whereas the ask is 1.12057. This means that selling 1€ for $1.12044 (bid) and buying 1€ for $1.12057 (ask) is possible.
Investors should note that the bid price is always lower than the ask price, and a smaller difference between the two prices is more beneficial. However, some brokers may increase the ask price, which results in a larger spread. This enables them to earn a higher profit instead of charging a fixed commission for the trade.
One important aspect of pricing to note is that a pip is the unit used to measure spreads, earnings, and losses.
What Is Forex Trading: Three Ways to Trade Forex
The majority of forex trading is not intended for currency exchange purposes, such as those encountered during travel, but is instead focused on anticipating future price fluctuations, similar to the approach taken in stock trading.
So what is forex trading for investors? Forex traders, just like stock traders, aim to acquire currencies that they believe will appreciate in value compared to other currencies or dispose of currencies that they predict will lose their buying power.
Forex trading can be approached in three distinct methods, each catering to traders with different objectives. It is important to consider these options when determining the best strategy to pursue. The best forex mobile trading platforms may help you pursue several different strategies, such as these three methods:
- The spot market. The main forex market is responsible for exchanging currency pairs and establishing exchange rates in real-time, which are determined by supply and demand.
- The forward market. Forex traders have the option to refrain from making an immediate trade and instead opt for a private agreement with another trader to fix an exchange rate for a specific amount of currency on a future date.
- The futures market. The exchange market offers traders the option to choose a pre-defined contract to purchase or sell a fixed amount of currency at an agreed-upon exchange rate on a future date. This process takes place publicly on the exchange, unlike the forwards market, which is a private transaction.
Forex traders mainly use the futures and forward markets to either speculate or protect themselves from future fluctuations in currency prices. The exchange rates in these markets are determined by the spot market, which is the largest forex market and the primary location for most forex trade executions.
What Is Forex Trading: Forex Terms to Know
Each market has its own language. These are words to know to completely understand what is forex trading before engaging in it:
- Margin. Although traders can trade with leverage, it comes at a cost. They need to provide an initial deposit called the margin. The deposit is mandatory and cannot be avoided.
- Leverage. The size of the lots in forex trading can be a hindrance for some traders who may not want to invest a lot of money. However, using leverage, which means borrowing money, enables traders to take part in the forex market without having to put up the full amount of money that would be required otherwise.
- Bid-ask spread. Exchange rates are influenced by the bid, which is the highest price that buyers are willing to pay for a currency, and the ask, which is the minimum price that sellers require to sell the currency, just like other assets such as stocks. The bid-ask spread is the difference between these two amounts, which determines the executed value of trades.
- Currency pair. When it comes to forex trading, every transaction involves two currencies. Along with the commonly traded major currencies, there are also rarer trades involving exotic currencies from developing nations.
- Pip. A pip is an abbreviation for percentage in points, which is the minimum price shift that can occur in a currency pair. Forex prices are typically quoted in four decimal places, meaning that one pip is equivalent to 0.0001.
- Lot. In forex trading, a standardized unit of currency is referred to as a lot, which cannot be left out. The standard lot size is usually 100,000 units of currency. However, there are also smaller units available for trading, such as micro lots with 1,000 units and mini lots with 10,000 units.
What Is Forex Trading: What Moves the Forex Market?
What is forex trading in terms of market movement? Similar to other financial markets, the forex market is mainly influenced by the principles of supply and demand, and it is crucial to comprehend the factors that steer these elements. The profits you can earn if you master these factors are a big reason why you should trade forex.
Central banks are responsible for controlling supply and have the capacity to make decisions with a significant influence on the value of their respective currencies. For instance, quantitative easing entails supplying more money to an economy and may reduce a currency's value.
The basic interest rate of the economy is also under the control of central banks. If you purchase an asset in a currency with a high-interest rate, you might make more money. This may induce investors to flock to a country that has just raised its interest rates, strengthening its economy and boosting the value of its currency.
Nevertheless, higher interest rates may also make it more difficult to borrow money. If borrowing money costs more, investing becomes more difficult, and currencies may decline.
What is forex trading in context of news reports? Commercial banks and other investors often favor investing in nations with strong economic prospects. As a result, if positive news about a particular area breaks, it will encourage investment and raise demand for that region's currency.
The discrepancy between supply and demand will cause the price of the currency to increase in the absence of a comparable increase in the currency's supply. Similar to how negative news may limit investment and lower a currency's value. Currency, therefore, reflects the proclaimed economic health of the country or region it represents.
It is essential to review the economic calendar thoroughly to get an idea of what's coming up, with special emphasis on the inflation statistics:
- Retail sales
- Production reports
The mood of the market, which often swings in response to the news, may have a significant impact on the value of a currency. Traders will undertake transactions based on their forecasts for the future of a currency, and they may encourage others to do the same, causing demand to increase or decrease.
Market data websites for each market provide customer sentiment in addition to current prices and fundamentals.
What Is Forex Trading: Risks of Forex Trading
In order the answer the question, “What is forex trading, and is it right for me?" you should understand that Forex trading involves higher risks than other asset classes due to the use of leverage and margin.
Traders need to make large trades with the help of leverage because currency prices fluctuate constantly but only by small amounts. It is important for them to take advantage of these fluctuations.
If a trader wins, this leverage is wonderful since it may enhance gains. Nonetheless, it has the ability to escalate losses to the point where they exceed the initial loan amount. If you’re looking for a forex trading platform, you may want to check out our review of XTB and lower trading costs.
Individuals who use leverage are at risk of receiving margin calls, which could compel them to sell stocks that were bought with borrowed money at a lower price if a currency experiences significant depreciation. In addition to possible losses, transaction costs may stack up and diminish the value of a previously profitable agreement.
In addition, the Securities and Exchange Commission sends cautions about potential fraud or information that may be confusing to new traders. Foreign currency dealers are like little fish swimming in a pond of skilled, professional merchants.
As a result, the fact that private investors do not participate in forex trading as often may be favorable. According to DailyForex statistics, retail trading, also known as trading by non-professionals, accounts for just 5.5% of the entire global market, and some of the top online brokers do not even provide FX trading.
Regrettably, most of the small retailers who engage in forex trading find it difficult to make a profit. On average, 71% of the retail foreign exchange traders experienced losses, as per the data provided by CompareForexBrokers. Due to this fact, it is often advisable to let experts handle foreign exchange trading.
What Is Forex Trading: Why Forex Trading Matters for Average Consumers
So what is forex trading for me if its hard for me to get involved? While the average investor should avoid the foreign exchange market, what transpires there affects everyone. The real-time activity of the spot market will affect the prices we pay for exports and international flights.
If the value of the US dollar increases relative to the euro, for instance, it will be cheaper to go abroad and purchase imported goods, from cars to clothes, because your US dollars will purchase more euros. When the value of the dollar declines, it becomes more expensive to import items from outside, but companies that export goods abroad will benefit.
If you want to make a major purchase of imported items or travel outside the United States, it is prudent to keep an eye on the currency market's exchange rates.
What Is Forex Trading: Forex Trading vs. Stock Trading
If you find yourself asking, “What is forex trading compared to the stock market," you aren’t alone. There are various distinctions between forex trading and stock trading, such as the following:
- Due to the fact that traders operate in various time zones, the forex market is accessible round the clock for five days every week without any breaks.
- The prices of currencies tend to change quickly and in small amounts, which makes it difficult for investors to earn profits from minor trades. As a result, leverage or borrowed funds from brokers are commonly used when trading currencies.
- In forex trading, transactions occur directly between traders or through forex brokers and dealers without the involvement of a central exchange. It is an over-the-counter market.
What Is Forex Trading: FAQs
Besides the question, “What is forex trading," we’ve compiled a list of frequently asked questions related to forex trading.
How Is the Forex Market Regulated?
Although the forex market is of immense magnitude, it lacks significant regulation as there is no centralized authority to monitor it on a continuous basis. Instead, various national trading organizations across the globe oversee local forex trading and other markets to ensure that all forex service providers comply with specific regulations.
The Commodities Futures Trade Commission (CFTC) and the National Futures Association are the two main organizations in charge of overseeing the forex market in the United States.
Trading cryptocurrency is a different matter with its own challenges, such as knowing the difference between inflationary and deflationary cryptocurrencies.
How Much Money Is Traded on the Forex Market Daily?
The daily volume of forex transactions is around $5 trillion, with an hourly average of $220 billion. The market is primarily composed of corporations, institutions, governments, and currency speculators. Currency speculation constitutes about 90% of the total trading volume, and most of it is concentrated on the yen, euro, and US dollar.
What Are Gaps in Forex Trading?
To get to the bottom of what is forex trading, understanding gaps is important. In the world of trading, gaps refer to sudden upward or downward shifts in market prices that occur with little or no trading activity in between, leading to a disruption in the usual price pattern.
While gaps do exist in the forex market, they are comparatively infrequent due to the fact that forex is traded continuously for five days a week, 24 hours a day.
In some cases, gapping can happen in the forex market due to unexpected economic data being released or when trading resumes after a holiday or weekend. Even though the forex market is not open for speculative trading during the weekend, it remains accessible to central banks and associated organizations.
It is likely that there will be a gap between the opening price on a Monday morning and the closing price on the previous Saturday morning due to the possibility of a difference in prices.
How Much Does It Cost to Start Trading Forex?
When it comes to trading forex, the expenses involved are determined by the specific currency pairs you select for buying or selling. You can trade forex by using a margin, which implies that you only require a small part of the total trade value to initiate and sustain your position.
Although a margin isn't a visible cost, it does affect the overall affordability of your trade significantly. Apart from the margin, an additional cost incurred while trading is the spread. It is the variation between the buying and selling price of an asset. If you want to initiate a long position, you'll have to trade above the current market price (buy price).
Whereas, for a short position, you'll have to trade below the current market price (sell price). In case you don't close your position by the end of the trading day, you'll be liable to pay overnight funding charges.
When Is the Best Time to Trade the Forex Market?
Determining the optimal time to engage in forex trading is contingent upon one's individual risk tolerance, given that forex prices can be influenced by high liquidity and volatility. The opening of the London session at 3 am (EST) typically spurs increased liquidity and volatility as traders commence their interactions.
Liquidity in trading typically decreases after a few hours and increases again once the American session begins at approximately 9:30 am (EST).
The foreign exchange market operates 24 hours a day, five days a week, starting from 3 am on Sunday and ending at 5 pm on Friday (EST). This allows traders to choose a suitable time to trade and benefit from various active sessions without any time constraints.
It is important to keep in mind that the opening hours of the forex market will be affected by daylight savings time changes in certain countries.
How Do I Open a Forex Trading Account?
If you're interested in forex trading, there are plenty of options to open an account online through services like Prime XBT.
Conclusion: What Is Forex Trading?
A basic understanding of the foreign exchange market is crucial for anyone interested in participating in financial markets around the world. Forex trading is all about buying and selling national currencies, depending on the knowledge of world events and market trends, to turn a profit.
Successful forex trading depends on both an understanding of trading fundamentals and continually educating yourself on new trends. If you’re able to balance those two requirements, you can take advantage of the many opportunities available in the forex market and succeed in a dynamic market.