What is Forex Trading and How Does It Work

Key Takeaways

• The forex market operates 24 hours a day, five days a week

• Currencies always trade in pairs (e.g. EUR/USD); you are simultaneously buying one and selling another

• In forex trading, you can profit from prices rising (going long) or prices falling (going short).

• Leverage allows traders to control large market positions with a relatively small deposit of capital

What is Forex Trading?

Forex trading, also known as foreign exchange or FX trading, is the simultaneous act of buying one currency and selling another. All forex trades happen in pairs, such as EUR/USD. 

While some of this currency exchange happens for practical reasons, like international business or tourism, the vast majority of market activity is for speculation.

This means traders buy and sell currencies with the specific goal of profiting from changes in their exchange rates.

Real-World Example of Currency Exchange

To understand what is forex trading in simple terms, consider the standard currency exchange process. When you travel to Japan, you exchange your home currency (e.g. US Dollars) for Japanese Yen.

You have effectively participated in the forex market. You sold Dollars and bought Yen.

If you stay in Japan for a week and the value of the Yen rises against the Dollar while you are there, when you exchange your leftover Yen back to Dollars at the end of the trip, you will receive more Dollars than you started with, That difference is your profit.

Speculation vs Hedging

There are two primary motivations for participants in the forex market:

1. Hedging: Multinational corporations use forex hedging to protect themselves against unfavorable currency price changes that could hurt their business operations.
2. Speculation: Most retail traders engage in forex trading solely to make a profit from fluctuations in exchange rates. 

How Does Forex Trading Work?

When you engage in forex trading as a speculator, you are essentially buying "shares" in a particular country's economy. You buy a currency based on the belief that its economy will strengthen relative to another country's economy.

Going Long vs. Going Short
One of the unique benefits of forex trading compared to traditional stock investing is the ease with which you can profit from falling prices.

• Going Long (Buy): You buy a currency pair if you believe the first currency (base) will rise in value against the second currency.

• Going Short (Sell): You sell a currency pair if you believe the first currency will fall in value. This allows traders to potentially profit even during economic downturns. 

Step-by-Step Example of a Forex Trade

Let's walk through a practical example of how forex trading works using the EUR/USD pair.

1. Selection: You select EUR/USD at a price of 1:1000.
2. Analysis: You decide to Go Long (Buy)
3. Action: You buy 1 Standard Lot (100,000 units)
4. The Result: The price rises to 1.1050 (50pips)
5. The Profit: The price moved 50 "pips" in your favor. On a standard lot, this equates to a profit of approximately $500.

Forex Trading Terminology: Pairs, Spreads, and Pips

To fully grasp what is forex trading, you must understand the key terminology and mechanics that define every transaction.

What are Currency Pairs?

In forex trading, currencies are always quoted in pairs, such as EUR/USD or GBP/JPY, also known as forex pairs. This is because in every foreign exchange transaction, you are simultaneously buying one currency and selling another.

Base Currency

The first currency listed in the pair (e.g. EUR/USD). This is the currency you are buying are selling.

Quote Currency

The second currency listed (e.g. EUR/USD). This tells you how much of this currency is needed to but one unit of the base currency.

The most frequently traded pairs are known as the "Majors," and they always include the US Dollar (e.g., EUR/USD, GBP/USD, USD/JPY).

Understanding Currency Pair Quotes

Every currency pair quote includes two prices:

• Bid price: The price at which you can sell the base currency
• Ask price: The price at which you can buy the base currency

The difference between these prices is known as the spread, and it represents one of the primary transaction costs in forex trading.

Base and Quote Currencies

Figure 3: Illustrates Base and Quote Currencies

In the currency pair EUR/USD:

• EUR is the base currency
• USD is the quote currency

The exchange rate indicates how much-quoted currency (USD) is needed to purchase one unit of base currency (EUR). For example, if EUR/USD is quoted at 1.2000, 1 euro can be exchanged for 1.20 US dollars.

What is Pips and Lots in Forex?

Figure 4: Illustrates One Pip

What is a Pip in Forex?

A forex pip (percentage in point) is the smallest standardized price movement in forex trading:

• For most currency pairs: a 0.0001 change in price (fourth decimal place)
• For pairs involving Japanese yen: a 0.01 change in price (second decimal place)

For example, if EUR/USD moves from 1.2000 to 1.2001, it has moved one pip. Pipettes (or fractional pips) represent a 1/10 of a pip and are shown as the fifth decimal place in most currency pairs.

How to Calculate Pips in Forex?

For the calculation of pips, find the difference between two price levels. In most currency pairs, the fourth decimal represent one pip. With pairs with USD as the quote currency (EUR/USD, for example), the pip value is calculated by multiplying the lot size by 0.0001.

For pairs where the USD is the base currency (like USD.EUR), divide 0.0001 by the current exchange rate then multiply by lot size.

Example of Pip Value Calculation for a Standard Lot

Currency Pair Example: EUR/USD

Position Size: 1 standard lot = 10,000 EUR

Exchange Rate= 1.2000

One Pip Movement (0.0001)= 100,000 X 0.0001 =US$10

If you trade a mini lot (10,000 units), one pip=US$1.

If you trade a micro lot (1,000 units), one pip= US$0.10

What is a Lot in Forex Trading?

Figure 5: Illustrates One Lot

In forex trading, a lot refers to the standardized unit of measurement for trade size, with one standard lot equal to 100,000 units of the base currency. The size of the lot directly impacts the value of a pip. For a standard lot of EUR/USD, each pip movement represents a $10 change in value.

Calculating Profit and Loss

To calculate potential profit or loss in forex trading:For a long position (buying): Profit/Loss = (Closing Price - Opening Price) × Lot Size × Number of Lots
 
For a short position (selling): Profit/Loss = (Opening Price - Closing Price) × Lot Size × Number of Lots

Example Calculation

Trading scenario:

• Currency pair: EUR/USD

• Opening position: Buy 1 standard lot (100,000 units) at 1.2000

• Closing position: Sell at 1.2050

• Calculation: (1.2050 - 1.2000) × 100,000 = $500 profit

What is a Forex Trader?

A forex trader is someone who participates in the forex market by buying and selling currency pairs, with the objective of making profits from change in exchange rates. Traders may be individual retail traders or institutional traders, such as banks and hedge funds.

How to Become a Forex Trader?

There are several key steps you should do to become a forex trader:

1. Learn the fundamentals

Research, study, and understand key concepts involved in forex trading, such as currency pairs, pips, lots, spreads, leverage, margin, and how the market works. TMGM’s Trading Academy provides comprehensive coverage on these topics. 

2. Choose a trading broker that is reputable

To trade forex online, you will require a trading broker. To ensure the most safe and reliable one, ensure it is regulated, licensed and provides clear fee structures. TMGM fits all these criteria. 

3. Open and set up a trading account

Start with a paper trading account, which has virtual funds you can use to practice trading first, without the risk of losing real money. TMGM has a demo account with virtual funds and enables you to trade real forex pairs but without the monetary risk.

4. Start trading with smaller lots and scale up

Once you are ready to start trading, use small lot sizes, which limit your risk and avoid high leverage first. Once you’re comfortable with your trading ability, you can start to scale up.

5. Continue learning about forex trading as you go

 Stay informed about the market, the latest news, economic decisions, and central bank announcements, and improve your strategy over time. 

What is Leverage and Margin in Forex Trading?

What is Leverage in Forex?

Leverage allows forex traders to control a large position with a relatively small capital. It is expressed as a ratio, such as 30:1, which means you can maintain a position 30 times larger than your invested capital.

Leverage is a double-edged sword:

• It magnifies potential profits from favorable market movements
• It equally magnifies potential losses from adverse market movements

What is Margin in Forex Trading?

Margin in forex is the deposit required to open and maintain a leveraged position. It acts as collateral for the leveraged portion of the trading exposure.

Types of Margin

• Initial Margin: The percentage of the full trade value required to open a position. For example, with 30:1 leverage, the initial margin requirement would be 3.33% of the total position value.
• Maintenance Margin: The minimum account balance required to keep a position open. If your account equity falls below this level due to losses, you may receive a margin call requiring additional funds, or your positions may be automatically closed (stopped out).

How to Calculate Margin in Forex Trading

For a EUR/USD trade with:

• Position size: 1 standard lot (100,000 EUR)
• Current exchange rate: 1.2000
• Position value in USD: 120,000
• Leverage: 30:1
• Initial margin requirement: 120,000 ÷ 30 = $4,000

You need at least $4,000 in your account to open this position.

Risk Management with Leverage

Leverage in trading can amplify potential gains and losses, making risk management a crucial component of a sustainable strategy.

• Position Sizing: To mitigate excessive exposure, limit each trade to a small percentage of your total capital. A commonly recommended approach is risking no more than 1-2% per trade.
• Stop-Loss Orders: Always use stop-loss orders to define the maximum acceptable loss for each trade, ensuring that sudden market movements do not lead to significant capital drawdowns.
• Risk-Reward Ratio: Prioritize trades with a favorable risk-reward ratio, typically aiming for at least 1:2. This ensures that successful trades can offset potential losses over time.
• Leverage Reduction: While brokers may offer high leverage, consider using less than the maximum available to reduce risk exposure and prevent unnecessary liquidation.
• Stress Testing: Assess how different market conditions, including high volatility, may impact leveraged positions. This helps forex traders prepare for unexpected price fluctuations and adjust strategies accordingly.

Effective leverage management ensures controlled risk exposure and long-term sustainability in trading.

What is a Forex Market

Forex trading is decentralized and operates over the counter (OTC). Instead of a central exchange, transactions occur electronically between banks, brokers, institutions, and retail traders.

Figure 6: Illustrates the forex transactions each day 

The Evolution of Forex Trading

The modern forex market has undergone significant transformation since its origins:

• Pre-1970s: Fixed exchange rates under the Bretton Woods Agreement

• 1971: Transition to floating exchange rates following the collapse of Bretton Woods

• 1980s-1990s: Introduction of electronic trading platforms and expanded institutional access

• Early 2000s: Proliferation of online retail forex brokers, democratizing access for individual traders

• Present day: Advanced algorithmic trading, mobile platforms, and integration with other asset classes

Today's forex market represents a sophisticated ecosystem where central banks, commercial banks, investment firms, corporations, and retail traders interact continuously across global markets.

What Moves the Forex Market?

Economic Factors

Central Bank Policies

Central banks are crucial in shaping monetary policy, directly influencing currency values. Interest rates are a primary tool

Economic Indicators

Key economic releases that influence forex markets:

Geopolitical Events