What Is Forex Trading and How It Works

Discover what is Forex trading, how it works, and its various types, including major, minor, exotic, and regional pairs. Learn about effective strategies to better navigate the financial market.
10:39 AM, Apr 28, 2023
10:39 AM, Apr 28, 2023
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The worldwide market for trading foreign currencies, also known as Forex trading or FX, is called foreign exchange trading. Several Forex trading platforms exist today, with Prime XBT emerging as our top choice.

When exploring what is Forex trading, it’s important to mention that Forex is the largest market globally. The transactions in the FX market influence everything from the cost of imported clothing from China to the price of a margarita during a Mexican holiday. 

This article discusses everything you need to know about forex trading, from what it is, how it works, its different types, and how you can get started today!

>>Sign up and start Forex trading on Prime XBT today!

What Is Forex Trading?

So, what is Forex trading? Forex trading involves the exchange of one currency for another. This is done through trading currency pairs, where one currency is sold while another is bought. 

It is the process of buying and selling currencies to profit from the fluctuations in their exchange rates.

A currency pair is represented by a three-letter code consisting of two letters indicating the region and one indicating the currency. For instance, USD stands for the US dollar, and JPY for the Japanese yen. When trading USD/JPY, you are selling Japanese yen and buying US dollars.

The most commonly traded FOREX pairs include EUR/USD, GBP/EUR, and GBP/USD. Forex trading platforms usually categorize pairs to maintain organization.

What Is Forex Trading: Four Types of Forex Pairs

  • Major Pairs: Global Forex trading mainly comprises seven currencies that account for 80% of the total trade volume, which includes pairs like EUR/USD, USD/JPY, GBP/USD, and USD/CHF.
  • Minor Pairs: Certain currency pairs are not traded as often as others, and these pairs usually involve major currencies trading against each other without involving the US dollar. Some examples of such pairs are EUR/GBP, EUR/CHF, and GBP/JPY.
  • Exotics Pairs: The list of currency pairs that involve a strong currency compared to a weaker or developing economy's currency comprises USD/PLN, GBP/MXN, and EUR/CZK.
  • Regional Pairs: The pairs in the list are categorized based on their respective regions, which may include Scandinavia or Australasia. The list comprises currency pairs such as EUR/NOK, AUD/NZD, and AUD/SGD.

Most Forex transactions involve banks or individuals who aim to purchase a currency that will appreciate in value compared to the currency they are selling. 

Nevertheless, even if you have exchanged one currency for another, such as when traveling, you have essentially engaged in a Forex transaction.

>>Sign up and start Forex trading on Prime XBT today!

What Is Forex Trading: How Currencies Are Traded

Every currency is assigned a three-letter code, similar to a stock's ticker symbol. Although there are over 170 currencies in existence, the U.S. dollar is the most dominant in Forex trading, making it essential to know its code, which is USD. 

What is Forex trading? It is the act of exchanging these various currencies in a global market, aiming to profit from their fluctuating values.

The second most widely used currency in Forex trading is the euro, which is accepted in 19 countries of the European Union and has a code of EUR.

The most popular currencies, listed in order, include:

  • Japanese yen (JPY)
  • British Pound (GBP)
  • Australian dollar (AUD)
  • Swiss franc (CHF)
  • The Canadian dollar (CAD)
  • New Zealand dollar (NZD).

In Forex trading, every transaction involves two currencies. The major currency pairs, which consist of seven pairs, are responsible for approximately 75% of the total trading volume in the Forex market.

  • EUR/USD
  • NZD/USD
  • USD/CHF
  • AUD/USD
  • USD/JPY
  • GBP/USD
  • USD/CAD

What Is Forex Trading: How Forex Trades Are Quoted

Still, wondering what is Forex trading? It’s important to mention that each currency pair reflect the exchange rate between two currencies. To understand this concept better, let's take the example of EUR/USD, which shows the current exchange rate between the euro and the US dollar.

  • The base currency is the one on the left, which is the euro.
  • The quoted currency, the U.S. dollar, is on the right side.
  • The exchange rate measures how many units of the quoted currency are required to purchase one unit of the base currency. Therefore, the base currency is always denoted as a single unit. In contrast, the quoted currency fluctuates depending on the prevailing market conditions and the amount required to buy one unit of the base currency.
  • When the exchange rate of EUR/USD is 1.2, it indicates that one Euro can be purchased for 1.20 US dollars. Conversely, it also means obtaining one Euro will cost 1.20 US dollars.
  • If the exchange rate increases, it indicates that the base currency has appreciated compared to the quoted currency, which means that one euro can buy more U.S. dollars. On the other hand, if the exchange rate decreases, it implies that the base currency has depreciated.

Remember that currency pairs are typically displayed with the base currency coming first and the quote currency coming second. 

However, some currency pairs may be expressed differently due to historical convention. For instance, the conversion from USD to EUR is denoted as EUR/USD, not USD/EUR.

>>Sign up and start Forex trading on Prime XBT today!

What Is Forex Trading: Bidding and Asking Prices

When answering what is Forex trading, it’s important to note that it’s very similar to stock trading since currency quotes heavily rely on the bid and ask prices. These prices are associated with the base currency and may confuse as they indicate the dealer's position rather than yours. 

The bid price refers to the amount the dealer will pay for the base currency, in other words, the price at which you can sell it. 

On the other hand, the asking price refers to the price at which the dealer is willing to sell the base currency to you or the amount at which you can buy it.

  • The asking price informs you of the amount of the counter currency (in this case, the USD) needed to purchase one unit of the base currency (EUR).
  • You may find out how much of the counter currency you can purchase at the bid price by selling one unit of the base currency.
  • The spread is the difference between these two prices (the asking price minus the bid price).

When trading currency, the bid and ask prices are commonly displayed as EUR/USD bid/ask, with the asking price indicated by the last two digits. In the example of EUR/USD 1.12044/57, the bid price is 1.12044, and the asking price is 1.12057. 

The bid price is always lower than the asking price, and a smaller spread between the two is more favorable for investors. Some brokers may widen the spread by raising the asking price and keeping the extra profit instead of charging a commission. 

Finally, pricing in currency trading is measured in pips, and earnings and losses are calculated in this unit.

What Is Forex Trading: Three Ways to Trade Forex

What is Forex trading, and how to trade Forex? Most Forex transactions do not involve exchanging currencies for practical purposes such as traveling but rather involve speculating about the future movement of prices. 

Forex traders are similar to stock traders in that they aim to purchase currencies they believe will increase in value compared to other currencies or sell currencies they anticipate will decrease purchasing power.

The best Forex trading platforms use three district Forex trading cater to traders with diverse goals:

  • The spot market. Forex trading can be done in three distinct methods that cater to the needs of traders with different objectives.
  • The forward market. Forex traders can avoid immediate trade execution and instead make a private agreement with another trader to fix an exchange rate for a specified amount of currency on a future date. This method is binding and ensures certainty in the exchange rate.
  • The futures market. In the same way, traders have the option to choose a contract that has standardized terms for purchasing or selling a predetermined quantity of currency at a fixed exchange rate on a future date. This transaction occurs on an exchange platform instead of privately, as in the forward market.

Forex traders often use the forward and futures markets to speculate potential price fluctuations in currencies. 

These Forex markets rely on the activity in the spot market, which is the largest and where most trades occur, to determine exchange rates.

>>Sign up and start Forex trading on Prime XBT today!

What Is Forex Trading: Industry Jargon

Before exploring what is Forex trading, it's important to familiarize yourself with the specific terminology used in this market. 

Each market has its own unique language, so it's crucial to understand the words and phrases commonly used by the best Forex desktop trading platforms.

  • Currency pair. All trades in the Forex market involve two currencies. Apart from the commonly traded major currency pairs, there are also infrequently traded currency pairs known as exotics, which represent the currencies of emerging nations.
  • Pip. A pip, which stands for percentage in points, represents the minimum price fluctuation in a currency pair. Since Forex rates are typically stated with four decimal places, a pip equals 0.0001.
  • Bid-ask spread. Exchange rates, similar to stocks, are established by the highest price buyers are willing to pay (the bid) and the lowest price sellers are willing to accept (the ask). The difference between the bid and ask prices is known as the bid-ask spread, which determines the final value at which trades are executed. 
  • Lot. In Forex trading, a standardized unit of currency called a lot is used. The common size of a lot is 100,000 currency units, but traders can also use smaller sizes known as micro (1,000) and mini (10,000) lots. It is important to note that lot sizes are integral to Forex trading.
  • Leverage. The size of the lots in Forex trading may dissuade some traders from executing trades due to a large amount of money involved. However, leveraging, which involves borrowing money, enables traders to engage in the Forex market with less capital than would normally be required.
  • Margin. Although leverage trading provides advantages, it is not free of cost. To engage in this type of trading, traders are required to submit an initial deposit or margin.

What Is Forex Trading: Market Movers 

The foreign exchange market, also known as Forex, is mainly influenced by the principles of supply and demand

So, it is crucial to comprehend the factors that shape these forces to understand better the Forex market, which can help you improve your financial management situation.

Central Banks

The control of supply is in the hands of central banks, who have the authority to implement measures that can significantly impact the value of their currency. 

One such measure is quantitative easing, which involves injecting more money into an economy and can decrease the currency's price.

In addition, central banks have the power to regulate the base interest rate of an economy. Purchasing an asset in a currency with a high-interest rate can result in greater returns for investors. 

This can lead to an influx of investors in a country that has recently increased its interest rates, which can boost its economy and increase the value of its currency.

However, higher interest rates can also make borrowing more difficult. When borrowing becomes more expensive, investing becomes more challenging, weakening currencies.

>>Sign up and start Forex trading on Prime XBT today!

News Reports

Investors, including commercial banks, prefer to invest their money in countries with promising economic prospects. This means that positive news about a region's economy will attract investments and surge demand for that area's currency. 

However, if the supply of the currency does not increase proportionately, the demand-supply gap will drive up the currency's value. 

Conversely, if negative news surfaces, investors will shy away, leading to a decline in demand and the currency's value. Therefore, a country's currency usually indicates its economic well-being.

Check out our economic calendar for upcoming events and specifically focus on the inflation data.

  • Retail sales
  • GDP
  • Employment
  • Production reports

Market Sentiment

The reaction of the market to news can have a significant impact on the movement of currency prices. As noted in our review of Saxo, traders tend to follow the market sentiment and make trades based on their belief about a particular currency's direction. 

This can influence the demand for the currency and cause it to either increase or decrease. To keep track of the market sentiment, traders can refer to the clients' sentiment and live prices and fundamentals available on the market data pages for each market.

What Is Forex Trading: Risks 

When answering what is Forex trading, it’s vital to mention that it involves the use of leverage and margin, which makes it riskier than other asset types. 

The prices of currencies fluctuate frequently and in small amounts, which means traders need to execute large trades with leverage to earn profits

While leverage can amplify gains, it can also amplify losses, exceeding the initial borrowed amount. If a currency's value drops significantly, users of leverage may also encounter margin calls, which require them to sell currencies they bought with borrowed funds at a loss. 

It is important to note this potential risk when dealing with leverage. Additionally, transaction costs can accumulate, potentially reducing the profits earned from trade.

It is also essential to remember that foreign currency traders compete with experienced and professional traders. The Securities and Exchange Commission cautions new traders about potential fraud and misleading information. 

Fortunately, Forex trading is uncommon among individual investors, with retail trading only accounting for 5.5% of the global market. Additionally, some major online brokers do not even offer Forex trading. 

Even among those who engage in Forex trading, most struggle to make a profit. According to CompareForexBrokers, 71% of retail Forex traders lose money on average. For these reasons, it may be best for non-professionals to avoid Forex trading.

>>Sign up and start Forex trading on Prime XBT today!

What Is Forex Trading: Forex Trading for Average Consumers

Wondering what is Forex trading for average consumers? Although the Forex market may not be suitable for the average investor to participate in, its activities impact all of us. The current happenings in the spot market influence the expenses incurred while traveling abroad and the cost of exports.

If the U.S. dollar's value increases compared to the euro, it becomes more economical to travel abroad and purchase imported goods. Conversely, as the dollar weakens, the cost of traveling abroad and importing goods increases. 

However, companies that export goods abroad will benefit from this situation. So, it is advisable to keep a close eye on the exchange rates determined by the Forex market, especially if you plan to travel abroad or purchase an imported product significantly. 

What Is Forex Trading: Forex Trading vs. Stock Trading

What is Forex trading when compared to stock trading? Our CMC markets review states that Forex Forex differs from stocks in several ways:

  • Forex trades are made over the counter. It is usually carried out peer-to-peer or via Forex brokers and dealers rather than being facilitated through a centralized exchange.
  • Because currency values change quickly and minimally, it can be difficult for investors to profit from small trades. As a result, leveraging is commonly used in Forex trading, which involves borrowing money from the broker when trading currencies.
  • The Forex market is operational 24 hours a day, five days a week, because traders operate in different time zones.

>>Sign up and start Forex trading on Prime XBT today!

What Is Forex Trading: FAQs

What is Forex trading? Here, we answer a few frequently asked questions about what is Forex trading.

How Is the Forex Market Regulated?

Although the Forex market is massive, there is a lack of regulation due to the absence of a central governing body that can monitor it constantly. 

However, several national trading bodies oversee Forex trading within their countries and other markets to ensure that providers follow specific guidelines. 

The Commodities Futures Trade Commission (CFTC) and the National Futures Association are the primary agencies responsible for regulating the Forex market in the United States.

What Is Forex Trading Market Value and How Much Money Is Traded?

Daily, our review of XTB notes that Forex transactions worth around $5 trillion occur, averaging $220 billion per hour

The market comprises primarily institutions, corporations, governments, and currency speculators. Speculation comprises around 90% of the trading volume, with a significant portion focused on the US dollar, euro, and yen. 

What Is Forex Trading Gap? 

As noted in our Public.com review, the Forex trading gap refers to sudden fluctuations in price with little or no trading in between, disrupting the normal price pattern. 

While gaps can occur in Forex trading, they are not as frequent as in other markets since Forex is traded 24/5. Gaps may occur when unexpected economic data releases or trading resumes after a weekend or holiday. 

Though speculative trading is closed during weekends, central banks and associated organizations can still access the Forex market, leading to a gap between Monday's opening and closing prices.

How Much Does It Cost To Start Trading Forex?

When trading Forex, the cost is determined by the currency pairs you choose to buy or sell. Forex trading is typically done on margin, which requires a small percentage of the total value of the trade to open and maintain your position. 

While the margin is not a direct cost, it significantly impacts the affordability of your trade. Additionally, you must pay a spread, which refers to the difference between an asset's ‘buy’ and ‘sell’ price. 

If you want to open a long position, you will have to trade slightly above the market price (buy price), and for a short position, you will have to trade slightly below the market price (sell price). 

Lastly, if you do not close your position by the end of the trading day, you will incur overnight funding charges.

>>Sign up and start Forex trading on Prime XBT today!

When Is the Best Time To Trade the Forex Market?

When it comes to trading Forex, the ideal time will vary based on your individual risk tolerance. Forex prices can be influenced by both high liquidity and volatility. 

The London session, which begins at 3 am (EST), tends to surge in liquidity and volatility as traders interact. After a few hours, liquidity tends to decrease, but it will rise again when the American session opens at around 9:30 am (EST).

It's essential to note that the foreign exchange market operates 24 hours a day, five days a week, from 3 am Sunday to 5 pm Friday (EST), allowing traders to take advantage of various active sessions and choose a time that suits them. 

It's worth remembering that the opening hours of the Forex market can change when certain countries adjust to daylight savings time.

How Do I Open a Forex Trading Account?

If you're interested in Forex trading, find the right broker and review the accounts offered. Once done, you must provide information on an application regarding your experience, knowledge, and proof of identification. 

You will be registered with a username and password to access your account. Log in to the platform’s client portal and transfer funds into your account. Once your account is funded, you will be ready to start forex trading.

Adding any funds is not mandatory for most brokers until you're ready to trade. You can also create a demo account to try the best Forex mobile trading platforms and enhance your trading abilities before starting trading.

What Is Forex Trading: The Takeaway

Understanding what is Forex trading and how it works is important for people interested in participating in the global currency market. 

Forex trading or foreign exchange trading platforms, like our top choice Prime XBT, operate by exchanging one currency for another to profit from the fluctuations in exchange rates. 

With a range of currency pairs, including major, minor, exotic, and regional, traders can capitalize on the constant changes in currency values. 

Whether you are a seasoned trader or simply exchanging currencies for travel, engaging in Forex trading allows you to navigate the world of currencies and potentially profit from it.

>>Sign up and start Forex trading on Prime XBT today!

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