How does Forex work?
Reading time: 14 minutes
At the beginning of their trading career, there are many aspiring traders who will have trouble wrapping their mind around how Forex trading works, or if Forex trading 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.
False motives, unrealistic goals, greed, inappropriate haste, lack of effort, and insufficient knowledge are the main reasons why many of those who try jump-starting a trading career leave disappointed and empty handed. Before you do anything, sit back and think about how much there is behind the Forex market and how it works.
Ask yourself the following questions:
- What do I know about the basic principles of price formation for every asset in the world?
- What is the underlying structure of the trading industry?
- What is the nature of international economic interactions?
- What are the key principles of fundamental and technical schools of market analysis?
- What are the psychological intricacies of being a trader?
- What actually happens when a trader presses a button?
Let's start from the beginning:
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 with the aim to buy the same amount of apples, only now there are two vendors, both having the amount of apples you need. This means that there is 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.
Draw a Mental Map of the Industry Before You Get Lost
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 – financial brokers, 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.
What Does Any of This Have to do With the Powers That Be?
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 Forex trading 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.
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 training, expecting to make fortunes out of $10, in a few decisive 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.
How Does Forex Trading Work From a Practical Standpoint?
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. The difference between the bid and the ask is called the spread.
If you would like to learn more about Forex quotes, why not read our article?
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 who 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 on the chosen Forex platform, at the click of a mouse. 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 the trading strategy, 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 trader, 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 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.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.