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How Does Forex Trading Work?

How Does Forex Trading Work?

Wow, where do I start?  We have some great in depth Forex training materials, but today I will try and give you the basic understanding of Forex and how it works.  Let’s start out with, what does Forex mean?  Forex is short for Foreign Exchange.   So, it is all about exchange rates between different countries and their currencies.  For Example, if you are going on vacation to London and live in the US and want to know how many Pounds (Great Brittan’s Currency) your one dollar will by, you just need to check the exchange rate at your local bank.  You might see a quote like GBP/USD 1.6402; this means it will take $1.64 dollars to get you one pound in their currency.  Looks like it will be an expensive vacation!

Forex is one of the largest markets out there with over 4 billion traded each day.  It is open 24 hours a day Sunday through Friday.  Major banks and governments buy and sell the currency every day to it is one of the most liquid markets out there.  This is why many traders look to the forex to trade.

Now, that you know what Forex is, everything else will be simple.  Except maybe the “spread”, but we will cover that later and it really is not hard to follow.  From the above example, you went to your local bank to check on the exchange rate or change your money.  So, banks are the main entities that give you currency quotes.  You might say they compete for your business by trying to give you a better rate.  You can also change money at the airport, but those exchange rates would not be as good as your local bank.  Those little EUREX exchange shops have to make money.  They might quote the price at 1.6621, this means that it will cost you $1.66 for each pound you want to buy.  It does not seem like much, but if you change $1000  at the bank, you will get about 8 more Pounds than if you change it at the Airport.

Forex trading is all about the comparison of two different countries currency pairs and how they relate in value.  You might see EUR/USD, the rate between the Euro and the US dollar  or the USD/JPY the exchange rate between the US Dollar and the Japanese Yen.  Remember, the first pair that is listed is the base pair and so the rate you see is the value of that currency as compared to the second pair.  Always remember, the rate you see on the EUR/USD, think 1 EURO equals how many US dollars 1.3764 today.  Two weeks ago the value on the EUR/USD was 1.3291.  Again, the base pair EUR, one EURO will by 1.3764 Dollars.  So, the value of the Euro has been going up and the value of the Dollar has been going down.

In my first example GBP/USD 1.6402 is the value of the GBP as compared to the Dollar.  If the dollar gains in value against the GBP currency, would that $1.6402 go up or down in the GBPUSD?  It would go down, because they are a team one must go up and one must go down.  So, if the USD goes up in value the currency rate quote will go down.  If the GBP goes up in value as compared to the dollar then the currency quote will go up.  This is called a zero sum gain.  If the value Base pair goes up the secondary pair will go down.

You are almost ready to open a demo account in the Forex market.  We need to mention the “spread”, the difference between the buy and sell price.  Banks are in this to make money, just like brokers, so they don’t give you the option of buying and selling the currency pair at the same price.  So, if you buy a currency pair and then sell it right away you will lose money.  The amount you lose will be the difference in the Buy and Sell price.  You will see quotes like EUR/USD 1.2322/1.2324, the first number is the Bid (The price you sell at).  The second number is the Ask or Offer (The price you buy at).  The difference in the two prices is called the “spread”, In this case 2 pips.  I forgot to mention a “pip” (price index point) is the smallest price movement in the currency market.  Think of it like a stock price, they move in cents, but instead of cents say the word “pips”..104.01 to 104.02 and the spread is the price difference between the bid and the ask, which is 1 cent.

You now should have a good understanding of what the Forex market is.  The next step is to get more information on the markets and strategies to trade.  Learn about brokers and margin and risk and start on a demo account.  I would take the time and review one of our forex courses called Forex123.  This will go into much greater detail about how to trade forex.