Understanding the Forex Market A Beginner's Detailed Guide

In simple terms, the Forex market is a global hub where you can trade currencies. Many of us unknowingly have participated in the market, while others make a living out of it. For example, if you have travelled abroad and had to trade the currency of your home country with another currency, you took part in the Forex market.

With trillions of dollars exchanging hands every day, the Forex market is a big deal.

Basics of Forex Trading

Before getting an in-depth understanding of what the Forex market is, let’s get the simple things out of the way. This section will go into what Forex trading is, giving you a brief but clear idea of what happens in the currency market.

What Is Forex Trading?

Imagine you live in Europe and use euros (€) as your primary currency. You buy some USD (United States Dollar) in exchange for euros. A few days later, the price of dollars increases, and you decide to sell the USD you had, resulting in a profit. This is the basic idea of what happens in Forex trading.

Foreign exchange trading involves buying and selling one currency simultaneously. It is done in pairs of currencies, which represent the exchange rate between two nations. Purchasing the EUR/USD pair, for example, involves selling U.S. dollars simultaneously with buying euros.

Forex trading's primary objective is to profit from exchange rate fluctuations. If you trade, your task is to forecast how one currency's value will change in relation to another. Changing geopolitical events, economic data, and market perceptions alter the value of currencies.

Forex trading occurs in an over-the-counter (OTC) market, hence transactions—between banks, institutions, and individual traders—occur straight between participants without a centralized exchange.

Currency Pairs: Base Currency and Quote Currency

As we’ve mentioned before, currencies in the Forex market are always traded in pairs. For example, there is no point in buying dollars with dollars. Foreign exchange happens when you buy or sell one currency with another.

Each currency pair has two components:

Base Currency: This is the first currency listed in the pair. It represents the currency being bought or sold.
Quote Currency: This is the second currency in the pair. It shows the value of the base currency in terms of the quote currency.

The euro (EUR) is the base currency in the EUR/USD pair, while the U.S. dollar (USD) is the quote currency. If the exchange rate is 1.20, 1 euro is worth 1.20 US dollars.

Types of Currency Pairs

Currency pairs are categorised into three main types based on their trading volume, liquidity, and the economies they represent:

1. Major Currency Pairs

The most traded pairs on the Forex market are the major ones, which are made up of the world's most stable and liquid currencies. Their base or quote currency is always the U.S. dollar (USD). These pairs account for about 80% of all Forex trades.

These four are major currency pairs in the Forex market:

EUR/USD: Euro vs. U.S. Dollar
USD/JPY: U.S. Dollar vs. Japanese Yen
GBP/USD: British Pound vs. U.S. Dollar
USD/CHF: U.S. Dollar vs. Swiss Franc

2. Minor Currency Pairs

Cross-currency pairs, sometimes called minor currency pairs, exclude the U.S. dollar. Rather, they have big currencies like the euro, yen, or pound. Examples include:

EUR/GBP: Euro vs. British Pound
AUD/JPY: Australian Dollar vs. Japanese Yen
GBP/JPY: British Pound vs. Japanese Yen

3. Exotic Currency Pairs

Exotic pairs combine one major currency with the currency of a small or developing nation. Examples include:

USD/TRY: U.S. Dollar vs. Turkish Lira
EUR/SEK: Euro vs. Swedish Krona
GBP/ZAR: British Pound vs. South African Rand

Key Players in the Forex Market

When talking about Forex, people imagine a trader using software with charts to buy or sell currencies. While that’s the basic picture, there are many moving parts involved to keep this enormous industry moving. Let’s get familiar with the key players in the Forex market:

1. Central Banks

In the Forex market, central banks like the Federal Reserve (USA), the European Central Bank (ECB), and the Bank of Japan (BOJ) have a lot of power. Why? Because they determine the monetary policy of their own nations, therefore affecting the value of their currencies.

The primary roles of central banks in Forex are:

Controlling their currency and inflation.
Managing interest rates which directly affects the values of currencies.
Conducting foreign exchange interventions by buying or selling currencies to maintain economic stability.

For example, the ECB might lower interest rates or sell euros on the market to lessen their value if it considers the euro to be too strong and hurting exports.

2. Commercial Banks

The Forex market is held together by commercial banks, which handle a huge number of currency exchanges every day. For companies, governments, and people, banks including Deutsche Bank, Citibank, and JPMorgan Chase enable trade.

Central banks are in charge of interest rates and inflation. Commercial banks, on the other hand, do the following:

Helping clients exchange currencies for international trade and travel.
Engaging in Forex trading to profit from currency price movements.
Ensuring there’s enough supply and demand in the market.

Banks often operate in the interbank market, where they trade large amounts of currencies with one another.

3. Retail Traders

People like you and me who trade Forex online through brokers are retail traders. As online trading sites like MetaTrader and cTrader have become more popular, this group has expanded greatly. Traders use their predictions of currency values to make a profit. Forex trading is easier to do now, but you need to know what you're doing, have a plan, and be careful because it's risky.

4. Institutional Investors

Institutional investors are groups like hedge funds, pension funds, and asset management firms. Part of their investment plans is trading currencies. These organisations want to make sure they do not lose money because of changes in the value of the currency. That's the reason they trade on the Forex market. This behaviour also brings them profit, which enables them to diversify their investments. A hedge fund might purchase the Japanese yen, for example, if it thinks the currency will appreciate versus the U.S. dollar.

5. Governments

Governments trade on the Forex market to achieve their economic goals, like keeping their currency stable or making sure trade conditions are good. To keep reserve levels, a government could purchase or sell foreign currencies. Sometimes, they also function as central banks, ensuring the stability of the value of their own currency. Finally, governments naturally have to engage in this market as international debt is paid back with foreign currencies.

How the Forex Market Works

The Forex market is where currencies are bought and sold. Unlike a stock exchange, it doesn’t have a central location, making it unique and flexible. Let’s break it down into simple parts:

Decentralised Nature of the Market

The Forex market is decentralised, which means that trade doesn't take place in a single building like stocks do at the New York Stock Exchange. Rather, trading happens over the phone or online and connects traders worldwide.

Who Trades?

Traders, banks, businesses, and countries all deal with each other directly to exchange money. Because it's distributed, the market runs around the clock, allowing traders in many time zones to trade whenever they like.

Trading Sessions: Asian, European, and North American

Since the Forex market is open 24/5 (24 hours a day, 5 days a week), trading happens in different sessions based on the time zones of major financial hubs:

Asian Session: Starting in Tokyo, this covers Australia, China, and Japan. This is the first session of the day, during which the Australian dollar (AUD) and Japanese yen (JPY) are most traded.
European Session: This starts in London, the largest Forex trading hub in the world. During this session, currencies like the euro (EUR) and the British pound (GBP) are highly traded.
North American Session: This starts in New York. The U.S. dollar (USD) dominates this session because it’s the most traded currency in the world.

Every session carries varying degrees of activity. For example, when London and New York sessions meet, that's when it's busy. This is the time when the market shows maximum movement and possibilities.

Spot Market vs. Derivatives

In Forex, you can trade in two main ways: the spot market or the derivatives market. Here’s the difference:

Spot Market

The spot market is where you buy and sell currencies immediately at the current price (called the spot price). For example, today, you exchange euros (€) for U.S. dollars (USD) at the rate of 1 euro = 1.10 dollars. Most people trading Forex use the spot market because it’s simple and straightforward.

Derivatives Market

This is where you trade contracts based on what you think the currency will be worth in the future. There are three types of derivatives:

Futures: Contracts to buy or sell a currency at a set price on a specific date.
Options: Contracts give you the right (but not the obligation) to buy or sell a currency at a certain price.
Forwards: Customized contracts between two parties to trade a currency at a set price in the future.

Example: You may use a futures contract to lock in today's price if you believe the euro will appreciate versus the dollar over the following three months.

Large corporations or banks use derivatives to guard against future changes in the value of currency. A corporation importing goods from a different country, for example, might use futures to ensure it doesn't lose money if the value of the currency fluctuates.

Forex Market Terminology

If you recently started Forex trading, the terminology could overwhelm you. Calm yourself not to worry! Let's examine some of the phrases that you should be familiar with in a clear, simple way.

1. Pips, Lots, and Leverage

Pips

A pip is a unit of measurement for changes in the value of a pair of currencies. With most currencies measured to the fourth decimal place, one pip represents the smallest change in that value.

Example: If the EUR/USD rate changes from 1.2000 to 1.2001, it moves by 1 pip.

Lots

A lot is the size of your trade in the Forex market. There are three main types of lots:

Standard Lot: 100,000 units of currency.
Mini Lot: 10,000 units.
Micro Lot: 1,000 units.

Example: If you trade 1 standard lot of EUR/USD, you are trading 100,000 euros.

Leverage

Leverage allows you to control a large trade with a small amount of money.

Example: If your broker offers 100:1 leverage, you can trade $100,000 with just $1,000.

2. Bid and Ask Price

When trading currencies, you’ll see two prices:

Bid Price: The price at which you can sell a currency.
Ask Price: The price at which you can buy a currency.

Example: If EUR/USD shows 1.2000/1.2005:

1.2000 is the bid price (you can sell euros at this price).
1.2005 is the ask price (you can buy euros at this price).

3. Spread

The spread is the difference between the bid price and the ask price.

Example: If EUR/USD has a bid price of 1.2000 and an ask price of 1.2005, the spread is 0.0005, or 5 pips.

In commission-free dealing, spreads are how brokers make money. Why is it relevant? For you as a trader, a smaller spread indicates fewer expenses.

4. Margin and Margin Call

Margin

Margin is the amount of money you need to have in your trading account to open a position.

Example: If you use 100:1 leverage, you need a 1% margin. For a $100,000 trade, you’ll need $1,000 in your account.

Margin Call

A margin call results from losses, causing your account balance to go too low. In order to stop future losses, your broker may ask you to end your trades or contribute extra money if this occurs.

FAQs

What is the minimum investment for Forex trading?

You do not need a lot of money to start Forex trading. A few hundred dollars will be enough to begin your journey.

Is Forex trading legal in my country?

It depends on which country you live in. Countries like India and Bosnia have banned Forex trading. While some other countries have strict regulations.

Can beginners make money in Forex trading?

In short, no! Making money with Forex trading requires a strategic approach that can be achieved through a good understanding of the market and currency fluctuations.

Understanding the Forex Market – A Detailed Introduction for Beginners