Foreign exchange market: what is it and how does Forex trading work?
Many novice traders have trouble understanding how the Forex market works and whether Forex trading actually works. These questions point to the core of the problem – the wrong approach to starting a trade.
Is Forex trading worth it? Unrealistic goals, greed, false motives, misplaced haste and insufficient knowledge are the main reasons why many who try to start a career in trading are disappointed and leave empty-handed. Before doing anything, it is extremely important to understand what is behind the Forex market and how it works.
Let's start from the very beginning.
Forex Market: Supply and Demand
In economics, supply and demand is the model that explains pricing in a free competitive market. The price of a good is set at the point where the quantity demanded by the consumer is balanced by the quantity supplied by the producer.
Let's say you went to the grocery store. You need apples and there is only one person selling them. You agree on a price and make an exchange - a certain amount of money for a certain number of apples.
The next day, you again want to buy the same number of apples, but now there are two sellers, and both have the number of apples you need. That is, the supply exceeds the demand for apples. Competition between sellers will drive down the price of apples, as both understand that you are likely to buy cheaper apples, all other things being equal. Conversely, if the demand for apples exceeds the supply, the seller will increase the price of his apples, being sure that they will definitely be bought.
This law also applies to the foreign exchange market: every time a certain currency is bought, excess demand is created in the market, unbalancing the price and pushing it up. Similarly, whenever a certain currency is sold, an excess supply is created – again, throwing the price out of balance and pushing it down.
! The ever-changing supply and demand for currencies is what makes Forex charts change.
The Forex market is (in simple terms)
What is the Forex market and what is the function of the foreign exchange market?
Forex (from the English Foreign Exchange) is an international over-the-counter currency market where market participants trade (buy and sell) currency pairs.
So that everyone can easily understand how the Forex market works, let's imagine it as an ever-changing ocean. There are many fish in this ocean, large and small, depending on their purchasing power.
Who are the participants in the Forex market?
The largest market participants are multi-billion dollar national banks, multinational companies and hedge funds. Their monetary policy and trading decisions create the biggest waves and push prices the most out of balance. There are mid-sized companies such as private investors and companies in need of hedging and private banks. Then come the smaller players – financial brokers, smaller banks and smaller investors.
Most of the aforementioned market participants have direct access to the interbank Forex market, the market where all currency exchange transactions take place. They have this access simply because they have an amount of funds that exceeds a certain threshold. This way they can trade with each other without intermediaries.
The smallest players become retail Forex traders. You treat them too. The purchasing power of the average trader is usually so small compared to higher level traders that they need a Forex broker or bank to provide a trading account, financial leverage and access to the market via trading servers. Understanding how the Forex market works, as well as your position in it, will inspire you to exercise the necessary caution when trading.
Forex trading: what you need to know to work on Forex?
The value of a currency is measured by how much another currency can be bought with one unit of it. This is called a price quote. A quote always consists of two prices - bid (bid or ask price) and ask (ask or offer price). You buy currency at the ask price, and when you sell it, at the ask price.
Thus, the bank will always buy your currency a little cheaper and sell it to you at a higher rate. The spread is the difference between the bid and ask price, which is the commission you pay to a broker for providing services.
Bid and ask prices are available to market participants at any time, except when the market is closed. The trader receives quotes via the Internet from the broker who provided him with a trading account. In turn, the brokerage firm receives price quotes from its liquidity providers, i.e. banks.
Generally speaking, the more liquid the market, the smaller the spread. Usually there are no problems when trading on Forex, and there is more than enough liquidity. However, there are cases, for example, during the release of important news, when there are gaps (price gaps) due to strong price changes over very short periods of time.
The rest is simple Forex mechanics.
How Forex Works: How to Trade Forex?
So how does the foreign exchange market work? Trading in the foreign exchange market takes place at the click of a mouse in the trading platform that the trader has chosen for himself. When, for example, an order is placed to buy the EUR/USD currency pair, part of the funds from the trader's account is used to buy the base currency of the EUR/USD pair (in this case, the euro) and sell the quote currency (US dollars).
The order is placed either with a broker (Market Maker), or directly displayed on the interbank Forex market (ECN execution), where there are large players.
Further, depending on the trading strategy, the trader waits for the purchased currency to rise in price relative to the sold one. When the trader is satisfied with the profit, he closes the order, and the broker does the opposite - i.e. sells euros and buys dollars. When a trader places a sell order, the opposite process occurs.
The concepts of buying and selling in Forex can be confusing at first, because in each transaction one currency is exchanged for another, which means that each transaction is both a "buy" and a "sell" of a currency.
How Forex Works: Currency Market Analysis
Analysis is not only the key to success in trading, but to some extent the only thing that makes Forex trading really work and bring results. The two main schools of market analysis are fundamental analysis and technical analysis.
Fundamental analysis is a form of financial audit, only on a national scale, and sometimes the world. This is the oldest form of price forecasting, which is based on various elements of the economy - the current stage of the economic cycle, important events, future forecasts and their possible impact on the market.
Fundamental analysis takes into account a country's GDP (gross domestic product) and unemployment rate, interest rates and export volumes, wars, elections, natural disasters, and economic progress. The impact is weighted in terms of the impact on supply and demand. The impact is assessed in terms of the impact on supply and demand. Fundamental analysis requires an understanding of the international economy and factors not yet taken into account by the market.
The disadvantages of such an analysis include the element of uncertainty created by such a large number of data sources.
The advantage of fundamental analysis is that, when performed correctly, you can accurately predict fundamental price movements, which can help you make profits in the long run.
Technical analysis is a younger form of market analysis that relies on only two variables - time and price. Both factors are strictly quantifiable, taken into account by the market and are indisputable facts. This is why, for many, Forex trading brings better results when studying charts than when doing economic research.
Whether you are drawing support and resistance lines, identifying key levels, applying technical indicators, or comparing candles, you are trying to figure out how Forex trading works without analyzing the causes of supply and demand.
This is the only type of analysis available to traders with fast trading styles; for example, scalpers who profit from daily Forex volatility rather than trend following.
The advantage of the technical approach lies in the analysis of quantifiable information exactly in the form in which it was taken into account by the market.
The downside is that this information has already had an impact on the market. Technical analysts believe that price patterns and formations in the past can influence patterns in the future, which many fundamentalists find ridiculous.
Simply put, fundamental analysis is an economic detective story with elements of predicting the future, while technical analysis is a visual archeology of price and time combined with statistics.
Forex Trading: Trading Platform
Nowadays, almost all services have moved to an online format, including trading. Today you can trade Forex 24 hours a day using a trading app (trading platform).
A trading platform or trading terminal is the software that a trader uses to carry out trading activities.
To start trading on Forex, you must open an account with a reliable broker, download the platform to access the markets as an application or program on your computer. Everything you need to make transactions is already in the application.
If you want to start trading in the Forex market and thousands of other markets, the MetaTrader 5 platform is considered one of the best platforms to do so. It can be downloaded as:
- PC programs
- mobile device applications
- web terminal and trade directly from brauser.
- Traders can easily track the price movements of currency pairs and a wide range of other financial assets such as CFDs on stocks, commodities and stock indices, etc. The platform is also an analysis tool as it allows various charting methods as well as the use of technical indicators.
How to work in Forex: using leverage
Financial leverage is, in essence, a way to increase trading opportunities in a Forex trader's account. With the help of leverage, traders can enter into transactions with volumes up to 1000 times their capital.
Using leverage can increase a trader's profits. However, leverage is a double-edged sword as it can equally increase potential losses.
Foreign Exchange Market: Using Forex Trading Signals
Forex trading signals are recommendations for making transactions. Trading signals can be used in all markets, including stocks, commodity indices and Forex. However, Forex signals are by far the most common. Typically, these signals are generated either by the trading algorithm or by the trader performing the analysis.
Real-time Forex signals often include a currency pair, a trade entry price, a stop loss price, a trade exit price, and instructions to buy or sell at a specific time. Traders can receive these notifications via email, text messages or messengers. Not so long ago, traders also had the opportunity to subscribe to a trading signal provider and his trades will be automatically played on your trading account.
Using Forex Trading Robots
Using automated trading systems requires a lot of research to find the right software that you can trust to complete your trades. The prospect of relaxing and letting the automated trading system do all the work for you is tempting. That's what trading bots are for. A trading robot is a computer program based on a set of trading signals that helps to determine whether to buy or sell a certain currency pair at a particular moment in time.
Although it seems that this way of trading is simple and will bring you profit without much effort on your part, robots are not always reliable.
How to start trading on Forex?
Now that you know how the Forex market works, the most important question remains: how to start trading Forex. You can start working on the foreign exchange market in just a few steps:
- Choose a reliable broker
- Open a trading account with him and make a minimum deposit
- Download the trading platform
- Make your first trade!
- Many people think that today $100 is too little, however, if you decide to trade Forex, $100 will be enough to get you started. In fact, you can even make money on Forex without investment.
Over time and with the right trading strategy and risk management, trading can become a new source of income for you.
If you are new to trading, you may wish to limit your trading activity to a single currency pair before opening positions in multiple pairs on your account. Each currency pair has certain characteristics, and therefore the way to trade each of them will be different.
One of the best pairs for a novice trader is the EUR/USD pair.