How does Forex work?
How does Forex work? Who are the participants in the Forex market? What is the role of brokers on the Forex exchange? Who are bulls and bears in trading? What is spread, pips and Forex lots?
Good afternoon! The Forex market is a place where traders exchange currencies and make money on it. This is the largest financial market. At the end of 2019, the daily turnover on the Forex exchange amounted to $ 7.7 trillion, and experts predict this figure should increase to $ 10 trillion by the end of 2020. Forex trading began in 1971 and was conducted exclusively by large banks. But with the development of the Internet in 1997, everything changed, the liberalization of the market began, which allowed us to take part in Forex trading.
Forex trading refers to the exchange of currencies that are paired with each other to profit from changes in the exchange rate. It works in the same way as a currency exchange office in a bank, you buy at a lower rate and sell at a higher price, and vice versa. But unlike a currency exchanger, you get better rates and the ability to buy and sell currency without leaving your home.
In this article we will tell you how Forex works, who are bulls and bears on the stock exchange, what are the trading features that are important for all traders to know, and how to make money on Forex.
If you have not chosen a broker yet or want to switch to a reliable and trusted company, we recommend that you look at our Forex broker rating with honest feedback from traders.
Forex Market Participants
The Forex market has several participants. You need to understand who these people or organizations are, what role they play, and how you fit into the equation.
The Forex market does not have a physical site. Instead, he has a virtual platform, which is a network of computers. This network consists of large banks that act as suppliers of liquidity and constitute the main source of all Forex volumes, traded on the market.
The Interbank Foreign Exchange Market is the first level of this virtual exchange, exchanging trillions of different foreign currencies daily. At this level are the large commercial banks and central banks.
Central banks are legal entities that print money and can sometimes participate in the market to buy or sell local currency and affect the rate of exchange in that country. Examples of central banks that have intervened in the interbank market are the Bank of Japan and the Swiss National Bank.
In addition, 9 large banks are liquidity providers that trade huge volumes on the interbank market. These are Deutsche Bank (the largest volume), Citibank, Commerzbank AG, HSBC, JP Morgan, Bank of America, Barclays, UBS and Goldman Sachs. They generate all the liquidity that forms the basis for the interbank foreign exchange market.
The Interbank Market serves the following group of Forex players, which are global companies with many transnational transactions. Therefore, they have to exchange currencies in large volumes. These are companies such as Amazon, Tesla, Apple, etc.
Institutional trading firms such as hedge funds also participate in this category as they trade Forex directly with liquidity providers.
Next are retail Forex brokers who receive their liquidity in the interbank market and transfer it on a smaller scale, albeit at a higher price to their clients.
Forex brokers usually fulfill customer orders using an internal dealing center. These are the brokers that individual traders like you will deal with. These brokers are called "market makers".
Then there are individual traders who participate in the Forex market with small trading volumes. You will interact with the market using the platforms and trading accounts provided by retail Forex brokers.
To understand how Forex works, imagine the supply chain of the production of goods in the market:
- Manufacturing. Central banks sometimes intervene in the market by buying or selling large quantities of foreign currencies in exchange for local currency in order to achieve national monetary policy.
- Wholesale Market. Wholesalers are superbanks that provide liquidity. We also have top brokers and institutional traders here who trade at very high volumes.
- Retailers. These are market makers. They receive their positions in Forex from liquidity providers and form a liquidity bridge between banks and retail traders.
- Consumers. Retail traders like you and I are here.
This is the structure of the Forex market and how players interact with each other at different levels. Now let's take a look at various concepts related to how Forex trading works that may be important to your trading.
See also rating of the best Forex brokers.
A Forex chart is a representation of the price change of a currency pair. The price is displayed on the Y-axis, and the time period on the X-axis. Three types of charts are used in Forex: linear, candlestick and bars. You can read about the advantages and disadvantages of each of them here.
Forex Currency Pairs
Forex transactions are organized in currency pairs. You may notice that the price of one currency is expressed in conventional units of another currency.
Each currency pair has a base currency and a quote currency. In the example below, you can notice that EURUSD is composed of the Euro (base currency) and the US dollar (quote currency). At the time of the screenshot, the price of € 1 was equivalent to $ 1.2524, which means you would have to pay $ 1.2524 to get € 1.
There are more than 180 currencies in the world that create various combinations to form currency pairs. Most traders distinguish two groups of currency pairs: main pairs with USD (EURUSD, USDJPY, GBPUSD) and crosses, that is, all other currency pairs without the US dollar (EURGBP, GBPJPY, AUDCAD, etc.). For more information on which currency pairs to use in Forex trading, see here.
See also regulated brokers.
Who are bulls and bears in Forex?
Bulls and Bears describe traders who expect the price of a currency pair to rise (bulls) or fall (bears). Thus, bulls will look for opportunities to open “long positions” or buy, while bears will look for opportunities to open “short positions” or sell a currency pair.
For example, a bullish trader profited from the uptrend shown below by buying GBPUSD at a low price and selling or closing at a higher price.
Simply put, with an investment of $ 1,000, the trader bought £ 694 at an initial price of 1.4400, then when the price rose, he sold £ 694 for $ 1.6950 for $ 1,107 in return.
$ 1 107 - $ 1000 = $ 107 profit
In contrast, bearish traders can capitalize on a downtrend by short selling a currency pair. This means that a trader can sell a currency pair at a high price. Then, if the price falls, he can buy or close the trade at a lower price.
Who are Forex Brokers?
The broker is the intermediary between the retail trader (you) and the Forex market. There are two types of brokers: market makers and ECN / STP brokers.
The difference between both models is that market makers execute their clients' orders in-house, while ECN / STP brokers forward trade orders to a higher level execution location or the interbank market. Usually ECN / STP brokers require higher capital, but have low spreads, favorable prices and fast execution speed, therefore they are more preferable for active traders.
You can read our review "The best Forex broker for beginner traders" to get more information on how to choose the right broker.
See also what are ECN brokers.
Ask and Bid Prices
In most cases, when you travel abroad, you need to transfer money from your country to the currency of your destination. When your trip ends, you need to convert the surplus currency from your destination back to currency from your country. If you remember, there are two prices at the exchange office - for selling and buying currency.
The same principle applies to the Forex market, any currency pair has two prices: Ask and Bid. Ask is the price you will receive if you want to buy the base currency, and it will always be higher than the Bid price. On the other hand, you will receive the Bid price if you want to sell the base currency.
Take a look at the following GBPAUD chart:
If you want to buy Pound Sterling, you must use the Ask price, paying 1.8873 AUD per Pound. In contrast, if you wanted to sell GBP, you would use the Bid price, giving 1.8866 AUD per GBP.
Spread is the difference between the buy and sell prices of a currency pair. Every time you place a Forex trade, you need to pay the spread. Hence, this is the commission that the broker receives for each trade.
From the above GBPAUD example, we can calculate the spread as follows:
See also brokers with minimum spread.
Forex Quotes and Pips
A pip is the smallest measurement of a currency's price movement, equivalent to 0.0001. Depending on the broker you choose, you will receive 4-digit or 5-digit quotes. Some Forex brokers provide a 5-digit decimal system in which an additional decimal place is one tenth of the 4th digit value.
In both cases, one point is the minimum change that the price can go through. In the case of 4-digit quotes, the minimum change will be 0.0001 or 1 point, while in 5-digit quotes, the minimum price change will be 0.00001 pips. Also, it is important to note that the JPY pair has quotes with 3 zeros after the decimal point.
Let's take a look at the example below to help you better understand the difference between 4-digit and 5-digit quotes:
As you can see, the value in points remains the same.
Lot is the volume of a trade that a trader uses to set a position in Forex. A standard lot is equivalent to 1 lot and costs 100,000 units of the base currency.
The lot can be divided into mini lots (from 0.1 to 0.99 lots), which control the trading volume from 10,000 to 99,999 units of the base currency. Also, a lot can be divided into micro lots (from 0.01 to 0.099 lots), which are equivalent to a trading volume of 1000 to 9000 units of the base currency:
For example, if you want to buy EURUSD, 1 lot is equivalent to 100,000 euros. Suppose the Ask price is 1.23228. Therefore, to buy 1 lot, you will technically need 123,288 USD. Given that it is a large amount of money for most traders to get into the market, the concept of leverage plays a key role in helping traders open high volume trades without having huge capital available.
Leverage and Margin in Forex Trading
The Forex market works using leverage. This is because the volumes required to maintain liquidity at the interbank level are too large for retail traders. Market makers "close" this liquidity gap by giving their clients the leverage to manage large positions using less money.
For example, for typical institutional clients trading in the interbank market, up to 500 standard lots may be required, which is about $ 50,000,000. Can a retail trader afford it? The answer is no.
However, by providing a leverage of, say, 1: 100, a broker can offer 99% of the funds required for a transaction, which leaves the trader with less amount needed to open a trade. This amount is called the margin.
Here is an example of a EURUSD trade for 0.1 lots on a $ 500 account with 1:00 leverage:
For detailed information on how to trade with leverage and not lose your deposit, you can find out here .
See also what are cryptocurrency brokers.
Thus, we have considered all the basic conditions necessary to start trading on Forex - from understanding how Forex and players in the foreign exchange market work, to charts, quotes and leverage. The next step on your trading journey is to learn more about Forex Indicators and learn how to use the most popular trading platform MetaTrader 4.
Read also the article TOP 12 Popular Strategies in 2020.