What Is Forex Trading and How Does It Work?
Written by
Jacob Wade
Edited by
Emily Gadd
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Forex stands for “Foreign Exchange” and refers to the active trading of currencies — exchanging one currency for another. Investors buy one currency while selling another (known as currency pairs) in hopes of profiting from the difference in price and exchange rates.
Forex trading pairs — such as USD/EUR — allow traders to exchange between currencies instantly. There are major, minor and exotic trading pairs available for trading. Major pairs always include U.S. Dollars, minor pairs are between popular national currencies such as Euro and Chinese Yuan. Exotic trading pairs are usually between a major currency and an emerging market currency.
How Does Forex Trading Work?
Every day, foreign currencies go up and down in value relative to one another. As with anything that changes value, traders can profit from these movements.
Forex trading is similar to buying and selling other types of securities, like stocks. The main difference is that forex trading is done in pairs, such as EUR/USD (euro/U.S. dollar) or JPY/GBP (Japanese yen/British pound). When you make a forex trade, you sell one currency and buy another. You profit if the currency you buy moves up against the currency you sold.
For example, let’s say the exchange rate between the euro and the U.S. dollar is 1.40 to 1. If you buy 1,000 euros, you would pay $1,400 U.S. dollars. If the currency rate later moves to 1.50 to 1, you can sell those euros for $1,500, generating a profit of $100.
The forex market runs 24 hours a day during the week, making it a very liquid market. What surprises many investors is the size of the forex market, which is actually the largest financial market on Earth. The average daily traded volume is $7.5 trillion, according to the 2022 Triennial Central Bank Survey of FX and OTC derivatives markets. The New York Stock Exchange, on the other hand, trades an average daily volume of just over $1 trillion.
Forex is popular with institutional investors, hedge funds and other large investors due to how liquid the market is. Forex trading is used as a hedge against local and international currency drops, and traders usually employ leverage to profit off of minor price movements.
How to Trade Forex: Step-by-Step Guide
1. Choose a Forex Broker
To trade forex, you’ll need to first pick a broker. Not all brokers support forex trading, so you’ll need to compare the ones that do.
Make sure to compare broker requirements for trading forex (including account minimums) and make sure they are regulated by the Commodities Futures Trading Commission (CFTC). You’ll also want a brokerage with easy-to-use forex training tools and low fees.
2. Open a Trading Account
Once you sign up for a broker, you’ll want to open a trading account to be able to trade forex. Many brokers offer demo accounts to let you practice trades without using your own money. This can be a good way to test out your trading strategy without worrying about losing money.
Once you start trading, you can trade within a standard account, but if you want lower fees and tight spreads you’ll want to use an ECN account. These accounts match buyers and sellers directly and help you pay less when trading.
3. Learn to Read Forex Charts
Trading forex can be complicated, and you’ll need to learn how to read forex charts to understand how to place trade, take profits, and protect downside risk. Learning how to read candlestick charts on forex trading pairs helps you identify trading opportunities. Utilizing technical analysis and chart indicators can help you follow trends and create a trading strategy.
Practice makes perfect, so make sure to utilize your demo trading account to improve your technical analysis without risking your funds.
4. Develop a Trading Strategy
As you start placing trades, it’s important to learn a trading strategy that makes sense for your risk appetite, goals and available funds.
- Day trading: Day trading involves understanding global news stories, currency fluctuations and finding opportunities to buy and sell forex — even several times — in a single day to make a profit.
- Swing trading: Swing traders buy or sell short forex positions and ride the momentum for a set time to make a profit. Swing traders hold positions for a few days up to several weeks.
- Scalping: Forex traders that make multiple trades in quick succession to capitalize on price momentum in a single direction are called “scalpers.” This strategy is best for traders that can study charts and be able to execute trades quickly.
5. Place Your First Trade
Once you feel comfortable with your trading strategy and have practiced with your demo account, it’s time to place your first forex trade. You’ll need to understand the types of orders (market, limit, and stop-loss) to complete your order form.
6. Manage Risk and Monitor Trades
It’s important to protect yourself from losing money with stop-loss orders when you first start out. And don’t risk your whole account in a single trade when first starting out.
Setting specific “take-profit” levels helps you make less emotional decisions when you start to be in profit. You can sell off a portion of your position as prices rise to ensure you lock in gains along the way.
Benefits of Forex Trading
Forex trading is ideal to institutional traders and hedge funds that want to diversify investments and take advantage of the most liquid trading market in the world. The market is available 24/5 and you can take advantage of margin accounts to create leveraged positions.
Forex trading also offers the ability to make money when the market is falling. Currencies change in value all the time, and volatility is a forex trader’s best friend.
Forex Trading Strategies for Beginners
If you’re just getting started, it’s important to come up with a trading strategy that has a lower risk profile and is less complicated. You can start with fundamental analysis by studying how certain currency pairs react to market and global news. You should also stick with major pairs for less volatility at the beginning.
Strategies like trend following and breakout trading lets you quickly jump into a trade, ride the momentum of a position and exit quickly. It’s important to protect yourself from downside risk with stop-loss orders on your trades at first. Eventually you’ll be able to learn technical analysis to develop more sophisticated trades with a higher success rate.
FAQ
- What is the minimum amount needed to start forex trading?
- While some platforms let you trade forex with less than $100, a more realistic number is between $1,000 to $5,000 (which many brokers require). Forex trading that involves leverage requires a margin account and minimum $2,000 deposit (or more). And if you become a "pattern day trader" the minimum required deposit may be $25,000 or more.
- Is forex trading legal in the U.S. and other countries?
- Yes, you can trade forex in the U.S., but there are tight regulations around who has access and how it operates. Many countries around the world limit forex trading and some outright ban it.
- How do forex traders make money?
- Forex traders make money by trading one national currency for another. If the price of one currency or another changes, traders earn money from the difference between the old and new exchange rate of their chosen currency pair.
- What are the best forex trading platforms for beginners?
- There are several great forex trading platforms, but eToro and Forex.com both offer beginner-friendly user interfaces and low fees.
- Can you trade forex without leverage?
- Yes, most forex trading platforms offer no leverage trades. You simply have to deposit funds and only trade with the balance in your account, foregoing the leverage option on your order form.
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