How Does Forex Trading Work?
In this article
Forex, or the foreign exchange market, differs significantly from stock trading. Therefore, these differences often make Forex look exotic compared to the more familiar terms and techniques we associate with the stock market.
Despite the familiarity that the stock market enjoys, the Forex market is overwhelmingly the largest in the world.
What is Forex trading? Is Forex trading profitable, what makes this FX market so popular and how does Forex trading work?
How does Foreign Exchange Trading Work?
The Forex market is a global market for the trading of currencies. The fall of the gold standard happened in the 1970s. This led to most of the world currencies trading against each other on the global Forex market.
So, if you feel the Euro will rise against the British pound, you can make a trade reflecting that belief.
The performance of the economies that relate to each currency affects the values of currencies. The intervention of central banks in response to inflation, deflation, or a sluggish economy also affects these currencies.
Forex traders stay glued to economic reports like the CPI (Consumer Price Index) and hints of what the central banks will do about the interest rates.
Therefore, traders widely use economic calendars to stay on track of valuable financial reports worldwide.
It can frustrate stocks and commodities markets when there is no upward price movement.
Another good thing about the Forex market is that it’s much easier to “sell short” than in markets, such as the stock and commodities market–this is because of the Forex market, where trades always pit one currency against another currency.
You speculate that a currency will go up or down in value against another currency.
What are Currency Pairs?
Currency pairs are the financial instruments available to trade on the Forex market. These currency pairs represent the relationship between two currencies.
For example, when EURUSD is 1.33, the Euro is worth 1.33 US dollars. To better understand quotes, read our article on; what a Pip is in Forex.
The base currency refers to the first currency in a currency pair, while the quote currency refers to the latter.
The quote of a Forex pair represents how much of the quote currency corresponds to one unit of the base currency.
The most heavily traded Forex pair is, by far, the EURUSD. This pair makes up nearly a quarter of all Forex trading.
The major currencies, or majors for short, refer to the seven most heavily traded currency pairs in the Forex market. Each pair has the US dollar (USD) as a component. The major pairs are Euro/US dollar (EURUSD), US dollar/Japanese Yen (USDJPY), British pound/US dollar (GBPUSD), Australian dollar/US dollar (AUDUSD), US dollar/Swiss franc (USDCHF), New Zealand dollar/US dollar (NZDUSD) and US dollar/Canadian dollar (USDCAD).
What is Margin Trading?
Another distinguishing feature of Forex trading is its widespread use of margin. Leverage is a type of credit that is given to you by your Forex broker. You must put up a collateral amount, known as margin, to qualify for the leverage–this is how margin and leverage work together. Margin and leverage are two terms that the Forex community often uses interchangeably, but they are slightly different even though they relate to one another.
Ratios like 1:100, 1:200, or 1:500 express the amount of leverage involved. Read this article to learn what a margin is and how to calculate it.
Margin and leverage allow you to multiply your potential profits. Using the leverage of 1:20, you can increase your capital by 20 times your deposit. However, just as using leverage multiplies the gains you might receive, it also multiplies the losses you could encounter. Should you lose enough in any open trades where your equity is not sufficient, you may receive what we know as a margin call.
This automatically closes your trades because the collateral you used to back the leverage is gone.
That’s why it’s important to use leverage wisely and don’t abuse it. The potential for abusing leverage is one reason getting retail investor accounts in stock, and other trading markets is tough. Margin trading is a much more widely accepted part of Forex trading.
Getting Started with Forex
The best way to start Forex trading is to study it and learn as much as possible. If you want to get your hands dirty with it, do so with a demo account.
Never rush into live trading without proper education and experience. Many books and resources on the Internet helps explain how to start Forex trading.
The step-by-step guide to your first Forex trade
Step 1: Access the Forex Trading Platform.
Trading platforms are software interfaces provided by a forex broker to investors. Customers have access to Forex markets via a currency trading platform. There are many ways to trade Forex, including online web portals, mobile apps, download programs, and combinations of these options. Depending on the broker you choose, this will vary.
Step 2: Open the chart.
Next, open a chart and select a currency pair. To do this, you must select a timeframe. With a forex chart, you can see a graphic representation of the relative price movement between two currencies across various time frames.
Step 3: Add indicators
The currency trader will add technical indicators on the chart opened in Step 2. There will be customizable settings for the price, volume, and open interest technical indicators.
Technical indicators fall into two basic categories:
Overlays: Stock chart overlays use the same scale as Forex prices and is plotted above (overlaid) the price chart.
Oscillators: Indices that oscillate between a maximum and minimum are called oscillators. The indicators will appear above or below a price chart.
Step 4: Place an order.
The trader can then prepare to place the order after setting the technical indicators. We should place trades based on the trader’s intention and the entry and exit methods they intend to use.
Step 5: Determine the stop loss and take profit levels.
The trader will take profit and stop loss levels after opening an order. You can take this step if you wish, but it suggests you do so. Stop losses allow traders to limit their losses if the market moves unexpectedly.
The take-profit level will ensure that the trade is profitable upon exiting the market once a downward move occurs.
Step 6: Order confirmation.
Following the submission, you will need to wait for the order confirmation screen. Order confirmation screens serve as ticket numbers – which are useful later.
Step 7: The waiting period.
Although it may appear to be the simplest step, the second last one is the most trying. During step 7, you must wait for some time. When the order goes in, some traders suggest turning off the monitor and walking away from the market.
Step 8: Complete the trade.
The trade is now complete! The first trade a trader makes may cause profit or loss. Whatever the case, it should serve as an opportunity to learn forex trading.
Forex Brokers in South Africa
Like in much of the world, Forex trading is gaining popularity in South Africa. Brokers in South Africa must abide by the regulatory demands of the Financial Sector Conduct Authority (FSCA). Such requirements include having a certain amount of capital, a cap on the amount of leverage provided to traders, and a mechanism to redress grievances.
Other brokers from around the world also cater to traders in SA. They must abide by similar requirements by other regulatory agencies, such as the Australian Securities and Investments Commission (ASIC) and the UK’s Financial Conduct Authority (FCA).
Forex broker selection–3 key factors to consider
A central regulatory body does not oversee the Forex market, and beginners should seek regulations in their own country. Financial Sector Conduct Authority (FSCA) and other major financial centers will regulate South African Forex brokers.
Quality of service
Quality of service is extremely important when choosing a broker in South Africa. Several services are to consider, such as trading platforms, trading tools, and customer support.
It is possible and has been a great source of income to trade Forex online, but using the services of a broker will incur costs. Account opening fees, commissions per trade, rollover fees, and deposit and withdrawal charges are just a few of the charges that may be incurred.
The spot Forex market has always accounted for the largest daily trading volume because it trades in a real asset bigger than those traded in the futures and forward forex markets. Previously, forward and futures trading volumes were larger than spot trading. Because of online forex trading and the proliferation of forex brokers, forex spot markets have boosted trading volumes.
A spot market is a global marketplace for purchasing and selling currencies based on their current trading price. Several factors go into calculating that price, including supply and demand.
As well as interest rates, economic performance, and sentiment about ongoing political situations (both locally and internationally), it also includes a perception of future performance.
Forwards and Futures market
On OTC markets, a forward contract is a private contract between two parties to purchase a currency at a specific price at a future date.
As the name suggests, a futures contract is an agreement by two parties to do a physical exchange of a currency at a future date for a predetermined price. OTC trading is not allowed for futures markets.
Traders in the forward Forex market buy and sell contracts over the counter, with their terms determining the agreement.
Markets like the Chicago Mercantile Exchange (CME) and other public commodities exchanges buy and sell futures contracts based on standard sizes and settlement dates.
These traders don’t intend to take physical possession of the currency pair themselves; they may speculate about or hedge against future exchange rate fluctuations.
Uses of the Forex markets
Forex for hedging
Currency fluctuations in foreign markets can risk businesses doing business abroad. A currency exchange market provides a way for investors to hedge currency risk by setting a rate for the transaction.
A Forex trader can lock in an exchange rate in the forward and currency swaps markets by buying or selling currencies in advance.
Forex for speculation
Various factors influence the supply and demand for currencies, including interest rates, trade flows, tourism, and economic strength. There is an opportunity to profit from changes in a currency’s value that may cause it to increase or decrease.
Forecasting a weakening currency in a pair is the same as assuming a strengthening currency in the pair. Here are some steps you can take to get started trading Forex.
Learn about Forex
Although forex trading may seem simple, it is an entirely different project that requires specialized knowledge. For instance, leverage ratios are higher in forex trading than in equity trading, and different factors drive currency price movements. Forex trading courses for beginners are widely available online.
Set up a brokerage account
Before beginning forex trading, you need a brokerage account. Forex brokers charge no commissions. The spread (also referred to as a pip) between the market price of buying and selling is where they make money instead.
It is a good idea for new traders to open a micro forex trading account that has a low capital requirement. A broker can limit the amount of trade to 1,000 units using such retail investor accounts, which have variable trading limits.
As a point of reference, a standard account lot equals 100,000 units of currency. Micro forex accounts will help you determine your trading style and get more experience with forex trading.
Develop a trading strategy
Whether you can predict and time market movements, a trading strategy can help set guidelines and provide a framework for your trading. Trading strategies should consider your financial and personal circumstances.
You are considering how much cash you will put up for trading and how much risk you will take without burning out. Trading forex is largely a high-leverage activity. The risk is also worth it for those who take it.
Always be on top of your numbers
After trading, make sure you check your positions daily. Daily trade accounting is already available in most trading software. Be sure that you have sufficient cash in your account for future trades and that no pending positions need to close.
Cultivate emotional equilibrium
Trading forex is a rollercoaster ride full of emotional roller coasters and unanswered questions. Have you held onto your position for too long to gain more profits?
Do you know how you missed the report about low gross domestic product (GDP) numbers that lowered the value of your portfolio?
If you obsess over such unanswered questions, you can lead yourself down a confusing path. Keeping emotional equilibrium despite profits and losses is essential when trading. Discipline yourself for the position of the closing price.
Forex trading risks–revealed
Trading involves risks of any kind, and Forex Trading should not be taken lightly. To become a successful trader, it is important to arm yourself with knowledge, tips, and expert advice. The main risks are:
Trading with unregulated brokers.
There is a high level of regulation on the interbank market, but there is no standardization regarding Forex instruments. In some countries, Forex trading has no regulation at all.
The main reason for regulating Forex Brokers is to ensure that they undergo regular audits, inform their clients of certain changes in service, and so on. It ensures fairness and ethics in currency trading for all parties.
The traders are 100% responsible for their education, making the difference between winning and losing. To trade effectively, traders need a firm grasp of the factors that drive currency movement, the economic and political landscape in those economies, and global events.
It is common for leading Forex Brokers to provide educational materials and tutorials to their customers.
Factors impacting the Forex markets
Forex markets have excess supply and demand, making them highly liquid. In the forex markets, multiple factors are at play at any one time. Many factors influence financial markets, such as geopolitical events, economic indicators, and financial news.
Traders inevitably purchase an in-demand currency when other currencies are on sale. Therefore, the currency is worth more in the currency markets than other currencies. It is more common for traders to sell one currency and purchase another if the demand for that currency is low.
For example, the following economic indicators can impact the forex market:
- Jobs Reports
- Inflation Forecasts
- Consumer Sentiment
- Consumer Expenditure
- Manufacturing Numbers
Despite what you’re about to discover, there is a lot of speculation in the finance world. A country’s currency will rise in value if interest rates rise. If jobs report numbers are negative, that country’s currency value could be affected, and so forth.
Low unemployment means more people are employed, which is good for the economy. An increase in unemployment means there are more people without jobs.
Negative sentiment is a bellwether for the economy. A country’s or region’s economic calendar provides all of this information.
Advantages of Forex trading
The biggest advantage is the potential to earn high returns and become financially independent. Making enough money from Forex trading in South Africa would allow many traders to quit their day jobs. This will not be possible for everyone.
Traders should learn how to analyze markets, analyze data, chart, and understand how economic news affects the Forex market of South Africa. There are several advantages. Forex trading has over other forms of investment, including:
Accessibility: The ability to invest online using your smartphone or computer. Trading Forex is accessible to almost everyone.
24-hour market: Unlike stock exchanges, the Forex market operates five days a week, 24 hours a day.
Leverage: Forex trading involves leverage. Leverage enables traders to open large positions and increase profits with relatively little capital.
Short selling: Traders can make money by selling a currency pair when the price drops.
Low initial cost: It is relatively inexpensive to start forex trading. For most brokers, you’ll only need to deposit 100 USD to open an account. The minimum deposit for some brokers is as low as 5 or 10 dollars.
Disadvantages of Forex trading
Forex trading has a high level of risk as its main disadvantage. Most South Africans who trade Forex lose money when trading CFDs. Profitable trading requires skill, education, discipline, and caution.
Since the markets are never completely predictable, professional traders will lose money when trading CFDs with high leverage. Forex trading entails the following risks:
Leverage: Yes, this is also a benefit (see above). High borrowing levels will amplify your profits, but they will also magnify your losses.
Unpredictable volatility: The price of currencies can change rapidly during economic and political crises. There is no way to predict crisis events in most cases.
Unregulated brokers: Some brokers are not regulated at all or are poorly regulated. The Forex trader may have little recourse if they have a dispute with an unregulated or poorly regulated broker.
High trading costs and withdrawal fees: A few brokers charge high withdrawal fees or trading costs. A profitable trade can become a losing trade if trading fees are high. Profits are also eroding because of high withdrawal fees.
It isn’t easy to trade profitably. Forex trading is best done during daylight hours from Monday through Friday in South Africa.
Most people are also at work during this time. Investing in Forex can be time-consuming, and many beginners cannot devote all their time to their home computers.
Tips for beginner Forex traders
Here are a few tips for beginners before we discuss how to trade Forex:
- The Forex market requires a thorough understanding of how it operates. The Forex market is nothing more than a gambling game without education.
- Start trading with a demo account before investing real money.
- Market economics, data analysis, and technical analysis courses are available.
- Learn what moves the price of a single forex pair and when those moves occur if you intend to trade that currency pair a lot.
- It is always advisable to use an online Forex reputable and regulated broker. Ensure that you read the fine print in the client contract.
- Forex brokers do not allow you to withdraw their bonuses. Supplementing your trading account is the only way to use these.
- Make sure the broker you choose offers negative balance protection. A negative balance protects you from liability after a loss, so you don’t owe your broker any money.
- Before you test your trading strategy on the live market, develop a demo account and test it out.
- Your trading account should contain a certain amount of money. It is always a good idea to never overuse your credit card.
- It would help if you only risked a small portion of your account balance at a time. There is always a possibility of bad luck wiping out your account even if your trading strategy has a 70% win rate.
- Put a stop-loss in place. A small loss is better than losing everything all at once.
- Professional Forex traders also lose money when trading CFDs. Don’t abandon your trading strategy when you lose a trade. It is essential to maintain consistency.
Important Forex trading terms
Pips: Pips stand for percentage points. A pip is a fractional unit of measurement in Forex trading, except for the Japanese Yen, which represents the second decimal place.
We measure financial assets in pips, a unit used to measure price changes. The term appears throughout all financial markets as a measurement unit.
Spread: This is the difference between a stock’s price at the time of purchase and its sale price, measured in pip (see above). Variable spreads are more common in Forex trading than fixed spreads.
Lots: A lot is a unit of measurement for Forex’s daily trading volume. A lot of EUR/USD is €100,000. A lot of EUR/USD is a 100,000-unit pair of currencies. There are 10 000 mini lots and 1000 micro lots for each pair.
Margin: This is the money you need to maintain your position. As a percentage of your total trades, it is a reserve portion of your account capital.
Leverage: When retail investors and Forex traders borrow money from a broker to open a larger position in the market, they call it leverage.
The leverage available to foreign exchange traders allows them to open positions hundreds of times larger than their initial capital. It is important to manage risk carefully as it will amplify gains and increase the chances of losing money rapidly due to leverage.
Negative balance protection: This is an insurance policy. Your retail investor accounts lose money with leveraged accounts, sending your trading account into negative territory.
The Forex trader will be liable for the negative balance owed to the broker. Many brokers offer negative balance protection, so institutional traders will never owe them any money.
Major Pairs: The biggest currency pairs are the major currencies. The major currency pairs are:
- EUR/USD (Euro/United States dollar)–the most traded pair
- USD/JPY (the United States dollar/Japanese yen)
- GBP/USD (Great British Pound/United States dollar)
- AUD/USD (Australian dollar/United States dollar)
- USD/CAD (the United States dollar/Canadian dollar)
- USD/CHF (the United States dollar/Swiss franc)
- NZD/USD (New Zealand dollar/United States dollar
CFDs: we know Contracts for Difference as CFDs. A CFD is a derivative instrument based on the underlying asset’s value. A CFD trade’s underlying asset (Forex, indices, commodities, or shares) does not belong to the CFD broker or trader. CFDs are complex instruments with a high risk of losing money due to leverage.
Why do people trade currencies?
A company or trader uses Foreign exchange to hedge their positions or speculate on the market. A trader uses the former to profit from currency price fluctuations, while a manufacturer uses the latter to lock overseas sales and manufacturing currency prices.
Are Forex markets volatile?
A major characteristic of forex markets is liquidity. They are, therefore, less volatile than other markets, like real estate. A particular currency’s volatility varies on several factors, including the country’s politics and economy.
Thus, events such as payment defaults or imbalances in trading relationships with other currency pairs can trigger important volatility.
Are Forex markets regulated?
Depending on the jurisdiction, forex trade regulations may differ. It is easier for countries like the United States to conduct forex trades because their infrastructure and markets are sophisticated.
Because of this, the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) heavily regulate forex trades there. However, forex trades use a high level of leverage, so developing countries like India and China restrict firms’ use and capital.
A majority of forex trades take place in Europe. A UK regulator oversees and regulates forex trades through the Financial Conduct Authority (FCA).
Which currency pairs can I trade in?
A currency with a high liquidity level has a ready market, so its price responds to external events smoothly and predictably. Dollars are the world’s most traded currency pairs.
Six of the seven currency pairs with the most liquidity on the market feature it. It is, however, difficult to trade currency pairs with low liquidity in large lots without important market movement affecting the price.
Currency of this type typically exists in developing countries. With exotic pairs, these currencies trade with currency pairs from developed countries. A pair such as USD/INR (The first currency is the United States dollar, and the second currency is the Indian rupee) is considered exotic.
How do I get started with Forex trading?
It is important to become familiar with the terminology, and operations of the forex market before trading. Next, you must determine your risk tolerance and financial situation before developing a trading strategy.
As a final step, open an account with a brokerage. Trading currencies has never been easier than today, with foreign exchange accounts easily opened and funded online.
Forex trading is a global market with exciting and important differences from national stock and commodities markets.
Instead of companies or commodities, you are trading currencies against each other. These currencies pitted against each other are called currency pairs, which you buy and sell in the Forex market.
Margin trading in the Forex market is much more accessible than in stock and commodities trading, giving you fantastic profit potential if you use it wisely.
Forex trading is always gaining popularity in South Africa, just as it is in most parts of the world.
Jason Morgan is an experienced forex analyst and writer with a deep understanding of the financial markets. With over 13+ years of industry experience, he has honed his skills in analyzing and forecasting currency movements, providing valuable insights to traders and investors.
Forex Content Writer | Market Analyst