What is Forex Trading and How Does It Work

Key Takeaways

• Forex (FX) is a 24-hour, five-day over-the-counter market where currencies trade in pairs (e.g., EUR/USD), with a daily turnover exceeding 9.6 trillion US dollars.

• Each quote represents the price of one unit of the base currency in terms of the quote currency; the bid-ask spread constitutes a primary trading cost.

• Price movements are measured in pips (0.0001 for most pairs, 0.01 for JPY pairs), and the lot size determines pip value and overall profit or loss.

• Traders can take long or short positions, and leverage allows control of larger positions but also amplifies losses, making position sizing and stop-loss orders essential.

What is Forex Trading?

Forex trading, also known as foreign exchange or FX trading, involves simultaneously buying one currency and selling another, aiming to profit from fluctuations in exchange rates. All forex trades occur in pairs, such as EUR/USD. 

The forex market operates 24 hours a day, five days a week, with forex market hours covering major financial centers such as London, New York, and Tokyo, and a daily trading volume exceeding $9.6 trillion. 

How Does Forex Trading Work?

Forex trading functions similarly to any financial exchange where one asset is swapped for another, typically executed via online platforms such as MetaTrader 4 (MT4).

In this context, forex traders buy one currency while simultaneously selling another. The market price of a currency pair indicates how much of the quote currency is required to purchase one unit of the base currency.

For example, if the GBP/USD pair is quoted at 1.2500, it means 1 British pound is equivalent to 1.25 US dollars.

Each currency is identified by a three-letter ISO code, facilitating efficient trade execution. Below are some common currency codes:

• USD – US Dollar
• EUR – Euro
• GBP – British Pound
• JPY – Japanese Yen
• AUD – Australian Dollar

These codes enable traders to quickly identify and trade currency pairs efficiently.

Figure 1 : Illustrates various unique currency codes

Forex Trading Fundamentals

What are Currency Pairs?

A currency pair, also called a forex pair, is the quotation of two different currencies, with the first currency being the base and the second the quote. The exchange rate indicates how much of the quote currency is required to purchase one unit of the base currency. 

For example, in the pair EUR/USD, the euro is the base currency and the US dollar is the quote currency, meaning a certain amount of US dollars is needed to buy one euro.

What are Major Currency Pairs?

Major currency pairs are the most actively traded pairs in the forex market, all of which include the US dollar (USD). 

They are characterized by high liquidity, tight spreads, and significant trading volume. The seven primary pairs are EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CAD, USD/CHF, and NZD/USD.

Figure 2: Illustrates major currency pairs

Minor and Exotic Pairs

• Minor pairs: Combinations of major currencies excluding the USD (e.g., EUR/GBP, GBP/JPY)
• Exotic pairs: Combinations of a major currency with the currency of an emerging or smaller economy (e.g., USD/TRY, EUR/ZAR)

Understanding Currency Pair Quotes

Each 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 called the spread, representing one of the main 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 of the quote currency (USD) is needed to purchase one unit of the base currency (EUR). For example, if EUR/USD is quoted at 1.2000, one euro can be exchanged for 1.20 US dollars.

What are 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 increment in forex trading:

• For most currency pairs: a 0.0001 change in price (fourth decimal place)
• For pairs involving the 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 (fractional pips) represent one-tenth of a pip and appear as the fifth decimal place in most currency pairs.

How to Calculate Pips in Forex?

To calculate pips, find the difference between two price levels. For most currency pairs, the fourth decimal place represents one pip. For pairs with USD as the quote currency (e.g., EUR/USD), pip value is calculated by multiplying the lot size by 0.0001.

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

Example of Pip Value Calculation for a Standard Lot

Currency Pair Example: EUR/USD

Position Size: 1 standard lot = 100,000 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 equals US$1.

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

What is a Lot in Forex Trading?

Figure 5: Illustrates One Lot

In forex trading, a lot is the standardized unit of trade size, with one standard lot equaling 100,000 units of the base currency. Lot size directly affects pip value. For a standard lot of EUR/USD, each pip movement corresponds to a $10 change in value.

Calculating Profit and Loss

To calculate potential profit or loss in forex trading:For a long position (buy): Profit/Loss = (Closing Price - Opening Price) × Lot Size × Number of Lots
 
For a short position (sell): 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 an individual or institution that participates in the forex market by buying and selling currency pairs, aiming to profit from fluctuations in exchange rates. Traders can be retail investors or institutional participants such as banks and hedge funds.

How to Become a Forex Trader?

Key steps to becoming a forex trader include:

1. Learn the fundamentals

Research, study, and understand essential forex concepts such as currency pairs, pips, lots, spreads, leverage, margin, and market mechanics. TMGM’’s Trading Academy  offers comprehensive coverage on these topics. 

2. Choose a reputable trading broker

To trade forex online, you need a trading broker. Ensure the broker is regulated, licensed, and transparent about fees. TMGM meets all these criteria. 

3. Open and set up a trading account

Begin with a demo account funded with virtual capital to practice trading without risking real money. TMGM offers a demo account  that allows trading real forex pairs risk-free.

4. Start trading with smaller lots and scale up

When ready, trade with small lot sizes and avoid high leverage initially. Increase position sizes gradually as your confidence and skill improve.

5. Continue learning about forex trading

 Stay updated on market developments, economic news, central bank announcements, and refine your trading strategy over time. 

What is Leverage and Margin in Forex Trading?

What is Leverage in Forex?

Leverage enables forex traders to control a large position with a relatively small amount of capital. It is expressed as a ratio, such as 30:1, meaning you can control a position 30 times larger than your invested capital.

Leverage is a double-edged sword:

• It amplifies potential profits from favorable market moves
• It also magnifies potential losses from adverse market moves

What is Margin in Forex Trading?

Margin in forex is the collateral deposit required to open and maintain a leveraged position. It serves as security for the leveraged exposure.

Types of Margin

• Initial Margin: The percentage of the total trade value required to open a position. For example, with 30:1 leverage, the initial margin is 3.33% of the position size.
• Maintenance Margin: The minimum account equity required to keep a position open. If equity falls below this due to losses, you may receive a margin call to add funds, or positions may be liquidated (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 can magnify both gains and losses, making risk management essential for sustainable trading.

• Position Sizing: Limit each trade to a small percentage of your total capital, typically risking no more than 1-2% per trade.
• Stop-Loss Orders: Always set stop-loss orders to cap potential losses and protect against sudden adverse market moves.
• Risk-Reward Ratio: Focus on trades with favorable risk-reward ratios, generally at least 1:2, ensuring profitable trades can offset losses over time.
• Leverage Reduction: Even if high leverage is available, consider using lower leverage to reduce risk and avoid forced liquidation.
• Stress Testing: Evaluate how different market conditions, including volatility spikes, affect leveraged positions to prepare and adjust strategies accordingly.

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

What is the Forex Market

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

Figure 6: Illustrates daily forex transactions 

The Evolution of Forex Trading

The modern forex market has evolved significantly since its inception:

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

• 1971: Shift to floating exchange rates following Bretton Woods collapse

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

• Early 2000s: Growth of online retail forex brokers, increasing access for individual traders

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

Today'’s forex market is 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 play a pivotal role in monetary policy, directly impacting currency valuations. Interest rates are a primary tool.

Economic Indicators

Key economic data releases influence forex markets:

Geopolitical Events