What is Forex Trading: Basics of the Foreign Exchange Market and Its Functions

The basics of Forex Trading

In forex trading, currencies are always traded in pairs, and therefore, one has to understand the relationship between two currencies before trading. Every currency pair has a value showing how much of the second currency can be purchased for the first. 

For instance, the foreign exchange quote EUR/USD means the price of the euro expressed in terms of the U.S. dollar. If the exchange rate is 1.20, it means 1 euro is equivalent to 1. 20 U.S. dollars. 

Aside from understanding the relation between the value of each currency pair and another, a trader also needs to understand the economic and political relationship between each country. These relationships can occasionally influence currency pair volatility or behavior. 

The Concept of Pips

A “pip” is an abbreviation of “percentage in point,” the lowest value a currency pair can move. In most currencies, a pip equals 0.0001 and 0.01 for most currencies and JPY pairs, respectively. Calculating pips is a very easy step; one has to identify the initial price of a currency and the expected price level for that currency, then do a little maths, as shown below.

Let us calculate EURUSD Pairs: 

Initial Quote: 1.1000

New / Expected  Quote: 1.1005

Pip Size: 0.0001 Calculate the Pip Movement for EURUSD:

New / Expected  Quote − Initial Quote = 1.1005 − 1.1000 = 0.0005 

Convert the Pip Movement into Pips

0.00050 / 0001 = 5 pips

For JPY pairs:

A pip is always equal to 0.01

Initial Quote: 110.00

New / Expected  Quote: 110.05

Pip Size: 0.01

Calculate the Pip Movement:

New Quote − Initial Quote = 110.05 − 110.00 = 0.05

Convert the Pip Movement into Pips:

0.05 / 0.01 = 5 pips

People trade forex for many reasons, but primarily to make a profit. However, traders use two approaches in forex trading: speculation and hedging.

Speculation

Speculation is the act of attempting to make profits out of changes in exchange rates of currencies. For example, if you think the euro will rise against the dollar, you can go for EUR/USD pairs.

In case the euro increases in value, one can sell the pair at a better price than the initial purchase price and hence make a profit. Indeed, speculation is very profitable, but it is important to consider the fact that forex is highly unpredictable and, therefore, very risky.

Speculation in forex goes both ways, you can speculate selling when you feel a currency is going to weaken compared to its pair, let say you are trading AUDUSD, and after your analysis you see that the Australian dollar is going to weaken in comparison to dollars. You can open a short or sell position in your broker and still make your profit. 

Hedging

Hedging is a mechanism deployed to minimize possible losses occasioned by unfavorable exchange rate fluctuations. It is common in organizations that transact business globally.

For instance, a company in the USA that has to receive payments in euros may sell euros and buy dollars to guarantee a good exchange rate and to avoid the situation when the euro has depreciated against the dollar.

Another instance is a trader who wants to place a buy trade on GBPJPY, who might want to diversify his portfolio and then buy and sell simultaneously using different brokers. This will minimize his losses and give me a more relaxed trading mindset. Hedging is mainly used by big companies or investors with large funds.

The brokers play a very crucial role in the forex trading business as they offer traders with the means to participate in the forex trading arena. These brokers provide trading floors such as the currency pairs price,  the currency spread, leverage and others, which will enable a trader to place open positions.

Leverage in trading

One of the unique characteristics of Forex trading is leverage, which enables a trader to control a large position using a small amount of money. For example, with 100:1 leverage, you can trade with $100,000 while you actually only have $1,000.

Leverage can increase the gains that can be made in the market but it also increases the risks that can be incurred hence the importance of prudent use of leverage.

Responsible Trading and Risk Management

Forex trading is all about management of risks and to be a successful trader one needs to be extremely disciplined. This involves such measures as placing stop loss to cut down on the amount of loss that can be incurred and avoiding over leverage.

Traders should also ensure that they continue to learn and use trial accounts before they start using real money. Also traders should cut down their emotions during trading, try not to be too excited during wins or sad during losses, a trader should understand that it is part of the game. 

Forex trading is a challenging and fast-paced industry, so it is necessary that you understand the fundamental concepts, as this will serve as a good starting point for more advanced studies. In this lesson, we started by defining the forex market and its operation, how currency pairs operate, and why people trade forex for profit or for protection.

However, like with any other form of trading, there are inherent risks as well as the possibility of making a lot of money in forex trading. Thus, the main conclusion is that forex trading should be done carefully, one should never stop learning, and when having doubts or questions – it is always wise to consult with financial experts. In this way, you can learn how to trade in the forex market effectively and make the right decisions. Well, break a leg!