Trading Forex: How does Forex Trading Work?
At the beginning of their trading career, many aspiring traders will have trouble wrapping their mind around how trading Forex works, or if it works at all. These questions point to the very heart of the problem – although they are taking the wrong approach in terms of addressing it.
Table of Contents
- How Forex Trading Works: Supply and Demand
- A Map of the Industry
- The Forex Market and Central Banks
- Forex Trading: Analysis is the Key
- Fortune Favours the Prepared
- Trading Forex: Let's Dive Deeper
- Forex Trading Apps
- Forex Trading: Using Leverage
- Trading Forex: Using Trading Signals
- Using Robots in Forex Trading
- Forex Trading: Start Small
How Forex Trading Works: Supply and Demand
In economics, supply and demand is a model that explains price formation in a free competitive marketplace. The price of goods is settled at a point where the quantity demanded by a consumer is balanced by the quantity supplied by a producer.
Let's say you are out there one day doing grocery shopping. You need apples, and there happens to be only a single vendor with just the right amount of apples. You negotiate, agree on the price, and make the exchange – a set amount of money for a set amount of apples. Both you and the vendor made a trade, getting precisely what you wanted.
The next day, you are out there again to buy the same amount of apples, only now there are two vendors, both having the number of apples you need. This means that there is a higher supply of apples then there is demand for them. The competition between vendors will push the price of apples down since both of them realise you will probably go for the cheaper apples, assuming all other things are equal. A new price will be set and you will make a deal with whichever vendor you see fit.
Alternatively, if that day you came with a friend who is also interested in apples, but only one vendor was there, there would be more demand for apples, but the supply would be lower. A vendor would recognise this and increase the price of their apples, knowing that both you and your friend will definitely buy all of their apples. This is the ABC of economics, and it is absolutely vital that you, as an aspiring trader, understand the simple logic of this example given, since it will help you to understand how the Forex market works.
Things may start to get more complicated from here on. Applying the apple market scenario to the foreign exchange market: every time a particular currency is bought, surplus demand is created on the market, throwing the price off balance, and pushing it higher. Similarly, every time a particular currency is sold, a surplus supply is created – again, throwing the price off balance and pushing it down.
The amount of impact is directly proportionate to the trading volume per deal. Big players, like national banks, for example, can cause a lot of disequilibrium by tampering with the supply of their home currency. Small players, like retail traders, can only influence the market ever so slightly, but still manage to do so through their sheer numbers.
The ever-changing supply and demand of currencies is what makes Forex charts tick. The philosophy of price balancing is key to understanding how online Forex trading works, since all of the economic events in the world are relevant to the market only in terms of how much they influence the supply and demand of an asset. It is also worth mentioning how much they influence the projected supply and demand of an asset.
Using our 'apple market' as an example, if one of the apple vendors went bankrupt this season, both you and your friend could expect the price of apples to rise before you even show up at the market.
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A Map of the Industry
When considering how the Forex market works, it is best imagined as an ever-changing ocean.
There are plenty of fish in that ocean, from big to small, depending on their buying power. There are multi-billion leviathans like national banks, multinational companies, and hedge funds. Their monetary policy and trading decisions make the biggest waves, throwing prices off balance the most. There are mid-sized companies – like private investors, and companies in need of hedging and private banks. Then there are the small players – 0, smaller banks and smaller investors.
Most of the aforementioned market participants have direct access to the Forex interbank, which is the market place where all the currency exchanges occur. They are allowed to simply because they are over a certain threshold of funds. This means that they can trade with each other without having to go through middlemen.
The smallest players are trying to survive long enough to become a retail Forex trader, which of course includes you. The buying power of a casual trader is usually so small compared to the higher level traders, that they need a Forex broker or a bank to provide a financially leveraged trading account, and access to the market via trading servers. Understanding how the Forex market works, as well as one's position in the scale of things, will inspire the necessary caution needed when trading.
The Forex Market and Central Banks
Forex is the market for currencies, as you should be aware by now, and currencies, unlike most other tradable assets, are economic tools, as much as they are economic indicators. Roughly speaking, if countries were companies, currencies would be their stock. Policy makers at central banks are the biggest tweakers of money supply, which makes their monetary policy decisions a major price-influencing factor on trading Forex and how it works.
The most obvious and simple example would be the interest rates set by the national bank of every country in the world. Since the US dollar, the Euro, the British Pound, and the Japanese Yen are the most traded currencies in the world, the Federal Reserve Bank, the European Central Bank, the Bank of England, and the Bank of Japan are respectively the biggest players and influencers. Understanding how this can affect the economy will help you to understand how the Forex market works.
When interest rates are increased, it becomes more expensive for market participants to borrow that currency from the bank. Momentarily, this causes a shortage in currency supply, and pushes the currency price up. Which is a good thing, right? Who wouldn't want a strong national currency?
Well, not really. In the short term, this means that there is less money to play with for business developments, less expendable household income and, ultimately, a slower rate of economic growth. However, this slows down inflation and slows down the inevitable build-up of debt – which, in the long term, is a very good thing.
Alternatively, when interest rates are cut, all market participants borrow more money. Momentarily, a surplus money supply is created and the currency price goes down. Short term, this can lead to business expansions, increased household spendings and a growing economy.
Again, this sounds really good, right?
Well, again, not really. If more money is borrowed, this means that more money is owed. In the long run, the accumulated bank credit that is generated can potentially create a storm in the form of a financial crisis. This is known as the 'macro economic cycle'. This is common to all capitalistic-type economies. National banks are continually trying to balance the scales by periodically raising and lowering interest rates.
This is referred to as the 'micro economic cycle'. These economic cycles are much like climate change cycles - in terms of being slow, unstoppable and very dangerous to the market participants that can't see them coming.
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Forex Trading: Analysis is the Key
Analysis is not only the key to success in trading, analysis, to some extent is the only thing that makes Forex trading really work. The two principal schools of market analysis are fundamental analysis and technical analysis.
Fundamental analysis is an evolved form of financial audit, only on the scale of a country or, sometimes, the world. This is the oldest form of price forecasting that looks at the various elements of an economy – its current stage in the cycle, relevant events, future prognosis, and the weighted possible impact on the market.
Fundamental analysis deals with a country's GDP (Gross Domestic Product) and unemployment rates, interest rates and export amounts, wars, elections, natural disasters, and economic advancements. Impact is weighted in terms of influence on supply and demand. Fundamental analysis requires an understanding of international economics, and deals with factors as yet unaccounted for by the market. This school of analysis works for investing and long-term trading.
The drawback of this type of analysis is the element of uncertainty that so many inputs create. The advantage of fundamental analysis is that when performed correctly, it predicts fundamental price movements that can help generate profit over a prolonged period of time.
Technical analysis is a younger form of market analysis that deals only with two variables – the time and the price. Both are strictly quantifiable, accounted for by the market, and are both undeniable facts. This is why for many, Forex trading works better when studying charts, rather than making economic inquiries.
Whether you are drawing support and resistance lines, identifying key levels, applying technical indicators, or comparing candlestick formations - you are figuring out how online trading Forex works, without looking into causes for supply and demand. Technical analysis can be used for both short and long term trading purposes. It is the only thing available to quick-style traders like scalpers, who make their profit from the infamous daily volatility on Forex, rather than trend following.
The strength of the technical approach is in analysing quantifiable information, precisely as it has been accounted for by the market. The drawback is that it has already affected the market. To trust the outcomes of technical analysis, one should subscribe to the notion that price formations in the past may have an effect on price formations in the future, which to many fundamentalists may seem ridiculous.
Putting it simply, fundamental analysis is an economic detective with elements of future forecasting, while technical analysis is visual price-time archaeology, combined with statistics.
Fortune Favours the Prepared
Lack of preparation is the very reason why so many aspiring traders fail before they ever manage to figure out how Forex trading works. Numerous books have been written about the trader's psychology, and how to avoid the pitfalls that a trader's mind is keen on slipping into. Again, the problem is the approach, and it is easy to get confused when everything is new.
Some Forex brokers, due to the nature of their business, often pitch Forex as a pseudo-scientific gambling attraction, that is basically like flipping a coin, only with a somewhat better methodology. As a result of such marketing, newcomers come with little or no Forex trading training, expecting to get rich from $10, in a few profitable clicks of a mouse. They jump into the market full of hope, and the market spits them back out, disappointed and empty handed.
Getting back to our point about being prepared, there's nothing that would prepare you better than a demo trading account – a risk-free way of trading in real-time conditions, to get a better feel for the market. It is highly recommended to immerse yourself in demo trading first, before moving on to the live markets. The results will speak for themselves.
Trading Forex: Let's Dive Deeper
A currency value is measured through how much of another currency it can buy. This is called a price quote. There are always two prices in a price quote - a bid and an ask. The ask price is used when purchasing a currency, while the bid price is used when selling. Note that the ask price of any financial instrument is at all times higher than the bid price. Thus, a bank will always buy your currency a bit cheaper, and sell it to you at a higher rate. In Forex trading there is a bid and ask price. How does the spread work Forex trading? The spread is the difference between the bid and ask.
If you would like to learn more about Forex quotes, why not read our article 'Understanding and Reading Forex Quotes'?
Both bid and ask prices are communicated between market participants almost instantaneously at all times, except when the market is closed. A trader receives quotes via the internet from the brokerage firm that provided the trading account for them. In turn, the broker firm receives price quotes from its liquidity providers – i.e. banks.
Generally speaking, the more liquidity, the tighter the spread, which is better for everybody. Usually, trading is ongoing, conducted smoothly, and liquidity is plentiful. However, there are times, like during major news releases, when price gaps occur due to major price shifts over the shortest periods of time.
The rest is simple Forex mechanics. Trading takes place at the click of a mouse on the Forex trading platform which has been chosen as the best by the trader. When, for example, a buy order is placed on the EUR/USD currency pair, a portion of funds from the trader's account is used to purchase the pair's base currency – in this case, the Euro – and sells the pair's quoted currency – the US dollar.
This is known as 'placing a buy order'. The order is placed either with the broker (Market Maker) or communicated directly to the Forex interbank market (ECN execution), where the big players are. It is important to understand that a trader can place an order to sell a currency that they do not 'own'.
Next, depending on trading strategies, a trader waits until the purchased currency grows in value, relative to the sold one. When the accumulated profit is satisfying to the trader, they close the order, and the broker performs the opposite set of transactions - i.e. selling euros and purchasing dollars. A reverse process takes place when a trader places a sell order.
The concepts of buying and selling in Forex can be confusing at first, since in every trade, one currency is exchanged for another, meaning that there is always both a 'buy' and a 'sell' in every trade. For a beginner, it might be easier to think of a currency pair as an abstract financial instrument to which a price is assigned by the market.
By now you should understand the basics behind Forex trading; the main driving forces of the market, its underlying structure in terms of key players, the two main schools of market analysis, and how online Forex trading works from a practical standpoint.
In case you were wondering, Forex trading is practised by traders all around the world. It's the same practice, regardless of where you are located. How does Forex trading work in the UK? It's, more or less, the same as it works in other countries, except for some differing regulations in different regions of the world that affect some aspects of trading.
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Forex Trading Apps
These days, almost every service has moved online, including trading. Today, you can trade Forex from a trading app or web service 24 hours a day. How does a Forex trading app work? They work like any other app. In the case of trading, you must open an account with a reliable broker, download a platform to access the markets as an app (or to your desktop). Everything you need to enter and exit trades is available to you in the app.
If you want to start trading Forex and thousands of other markets, MetaTrader 5 is commonly regarded as one of the best available platforms for doing so. It's available on desktop, web terminal and as an app for your mobile devices.
Traders can easily track the movement of Forex prices and a wide range of other financial assets, such CFDs on stocks, commodities and stock indices, to name a few.
The MetaTrader 5 Supreme Edition (MT5SE) is an add-on for MetaTrader developed by Admirals. Thanks to the MT5SE add-on, you can have access to 60+ additional features which are not offered in the stand-alone platform.
The good news is that both MetaTrader 5 and the MT5SE add-on are free to download for customers of Admirals. To download MetaTrader 5, click this banner:
Forex Trading: Using Leverage
Financial leverage is basically a boost for a Forex trader's account. With the help of leverage, traders can enter trades with as much as 1,000 times more than their capital. Traders use leverage to get access to larger volumes than they are able to trade with.
Using leverage can multiply a trader's returns. However, leverage is a double edge sword as multiplies potential losses by the same factor. You can find more information about how leverage works in Forex trading in our article, What is Leverage in Forex Trading?
Trading Forex: Using Trading Signals
Forex trading signals are recommendations for taking action on trades. Trading signals can be used in all markets, including stocks, commodities indices, and Forex. However, Forex signals are by far the most common. Typically, these FX signals are produced by either a trading algorithm or a human trader performing analysis.
Live Forex signals often involve a currency pair, an entry price, a stop loss price, a target price, and instructions to either buy or sell at a specific time. Traders can receive these notifications by email, text or another messaging app. Lately, however, it's become possible for traders to subscribe to a trading signal provider and have their trades reproduced in your trading account automatically.
One example of a trading signal is the moving average.
You can calculate a moving average (MA) using any set of data that changes over time, but with technical analysis in trading, traders mostly use it with price. A moving average is a continuous calculation of the mean average of a price over a determined period of time. The 'moving' part in the name is here because it calculates a new value as each time period ends and a new one begins. In doing this, the value of the average adjusts as the price changes over time.
For example, if we use a 30-day MA, the value will be the mean average of the price in the past 30 days. In other words, we sum up each of these 30 closing prices and divide them by 30. This value is calculated every day as we discard the oldest value in the set and add the most recent one. The moving average helps traders get a better understanding of price trends as the price fluctuates. It helps traders look beyond insignificant or unimportant shifts in the price, and see the longer-term trend of the market instead.
Using Robots in Forex Trading
Using automated trading systems requires much research to find the right kind of software that you can trust to correctly perform trades. Stepping away and letting an automatic trading system do the work for you can be tempting. This is where Forex robots come into use. A forex robot is a digital program that operates based on a set of forex trading signals to determine whether or not to buy or sell a currency pair at a specific time.
While they sound like an easy way to trade and earn profits without much work, they are not always as reliable as they seem to be. You can find more information about how Forex trading robots work in our article, What are the Best Forex Robots and Do They Really Work?.
Forex Trading: Start Small
While it is a common perception that $100 may not have significant purchasing power in the present day, it is worth noting that when engaging in Forex trading, this sum can serve as an initial capitalization point. Over time and with a sound trading and risk management strategy, it could become a new source of income for you.
At the same time, if you are interested in getting into the Forex market to try some practice trades, then it could be worth trying, if a $100 loss doesn't break your bank.
The key to succeeding as a trader is in having a sound trading strategy that you can stick to, no matter whether you have $100 or $100,000 in your trading account. Your strategy will also entail your analysis and ability to not trade on emotions.
The good news is that any sound trading plan can be applied to an account with $100 as some brokers, including Admirals, will let you open an account with as little as 1 GBP. Once you’ve developed your trading strategy and increased your balance through profitable trades, you'll then be able to increase the volume of your trades. To avoid large and unexpected losses, remember to incorporate sound money management into your trading plan.
If you’re new to trading, you may consider limiting your trading activity to one currency pair before entering positions in several pairs with your account. Each pair differs in how it trades due to the underlying fundamentals of each currency.
One of the best pairs for a beginner trader to start with is the euro against the U.S. dollar (EUR/USD). This is because of its high liquidity and tight spreads. This is one reason this is the most traded currency pair in the market. You can also easily access the economic news that will affect these markets, so the EUR/USD pair can be a good choice if you wish to start trading forex with $100.
Other articles you may find interesting:
- A Guide to Forex Trading Times
- Five Free Forex Indicators Every Trader Should Know
- The Best Swing Trading Strategy for 2021
Frequently Asked Questions
What is Forex trading?
Forex trading is the buying and selling of currencies in the foreign exchange market to profit from changes in their exchange rates. It involves trading currency pairs, such as EUR/USD (Euro/US Dollar).
How do I start Forex trading?
To start forex trading, follow these steps:
- Choose a reputable forex broker.
- Open a trading account with the chosen broker.
- Fund your account with the amount you want to trade.
- Learn basic forex concepts and trading strategies (start your forex education for more sustainable results).
- Practice with a demo account before trading with real money.
What are some key tips for successful Forex trading?
Successful forex trading requires:
- Having a clear trading plan and strategy.
- Using risk management tools like stop-loss orders.
- Staying updated on economic news and events.
- Avoiding emotional decision-making and overtrading.
- Continuously learning and adapting to market conditions.
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