Investing > What is Forex Trading?

What is Forex Trading?

Curious about forex trading but don’t know where to begin? You've come to the right place.

By
Reviewed by
Updated May 13, 2021

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Here’s a wild thought:

People can actually make money while staying home and never stepping foot outside.

And this isn’t a reference to people working from home due to COVID-19.

Since the lockdowns began, forex trading volumes increased threefold and are still rising—the North American market grew by 22% in late 2020 and isn’t slowing down. What this means is that the market is full of opportunity and trading is very rewarding—for those who know how to trade. 💡

We’re going to go out on a limb here and assume you’re one of the many people who are intrigued by the prospect of forex trading but have no clue how it really works. Is that about right? Trust us when we say… we get it. It’s dense, there are a lot of details, and it’s not too user-friendly to the uninitiated.

Luckily, we waded through the weeds to bring you a simple, blow-by-blow guide to your questions—what exactly is forex trading? How does it work? Is it profitable? Well buckle your seat-belt, bookmark this page, and let us walk you through it!

What you’ll learn
  • How Forex Trading Works
  • Understanding the Currency Market
  • Trading Currency Pairs
  • Intro to Currency Pairs
  • Essential Forex Terms
  • Forex Quotes Dissected
  • Spot, Forward, and Futures Markets
  • Example of a Trade
  • Pros and Cons of Forex Trading
  • Get Started with a Broker

How Forex Trading Works ⚙️

Forex (which is short for foreign exchange) may not be as familiar a household topic as stocks or real estate, but it’s actually the biggest market in existence—over $6.6 trillion is traded daily. Forex, simply put, is exchanging one currency for another in the hope of an increased return. 

Currencies all fluctuate up and down in value based on supply and demand, so a forex investor typically trades their currency for another that they anticipate to strengthen in the future. Perhaps the easiest way to understand what forex (FX) trading is would be to look at experiences you may have had when traveling! Here’s what we mean…

Understanding Forex through the Currency Market 🌍

Bobby has family in Newcastle-upon-Tyne, a lovely city in northern England. When he last flew from New York to visit them 1 American dollar (USD) was only worth 0.76 pound sterling (GBP). Bobby exchanged 100 USD for 76 GBP to buy things, but luckily, his family accommodated for everything and he didn’t spend a penny.

By the time he returned to the U.S., the dollar has had a good time and its value compared to the GBP rose after some news about Brexit made traders lose faith in the pound—now, one American dollar is worth 0.82 pound sterling. So, Bobby landed in New York with 76 GBP, which he now wanted to turn into USD. 

What do you know, Bobby got 108 USD from this trade and has more money now than what he started off with, all because of a fluctuation in exchange rates. This is the idea behind forex trading—change one currency for another, and then change it back once the conversion rates move to make a profit.

Each currency has a different (and constantly moving) value, and is designated by a 3 letter code, similar to the 4 letter codes that identify stocks. Major currencies that you may be familiar with include the American dollar (USD) and British pound sterling (GBP) as mentioned above, as well as Japanese yen (JPY), Chinese yuan (CNY), the Australian dollar (AUD), and many others. 

Every forex trade involves a pairing of two currencies. Let us explain!

The Different Groups of Currency Pairs 💹

Forex trades will always involve exchanging one currency for another. USD to euros (EUR), JSY to AUD; there are countless combinations that you can create and trade through your user-friendly brokerage platform, but they’ll each fit into one of the four types of trading pairs:

1. Major pairs – The big seven major pairings, or “majors”, are the seven major currencies in the world, and make up 75%-80% of all forex trades. The identifying factor is that ALL of them are paired with the USD. The seven major pairings include EUR/USD, USD/AUD, and USD/GBP.

2. Minor pairs – the minor pairs are less frequently traded. This usually consists of trading the major pairs against each other, NOT against the USD (i.e. GBP/JPY or EUR/GBP).

3. Regional pairs – this refers to pairings of currencies that are within the same region. One of the best examples of this would be the Australian dollar (AUD) traded with the New Zealand dollar (NZD). 

4. Exotic pairs – if you’re familiar with stock trading, an exotic pair might be most like a penny stock. This is trading a major currency against a small currency from a nation with an emerging economy, such as trading EUR/PLN (the Polish Zloty). These are typically a bit riskier and more volatile, but with higher potential gains. 

With the recent boom in cryptocurrencies over the past few years, you may also wonder if you can trade cryptos, like Bitcoin, in forex. Because Bitcoin is not tied to gold or the natural economic fluctuations of a national economy, regulators have still hesitated to consider Bitcoin to be a currency. 

Despite this, Bitcoin (BTC) can be traded in forex! It’s just not well-suited yet for most of the existing forex platforms.

Forex platforms may increasingly adapt to include crypto, at lower trading fees, but they aren’t the most popular crypto exchanges right now—however, if you want to start investing in Bitcoin, using a demo account at a crypto-friendly brokerage is a risk-free way to practice before using real money.

Essential Forex Terms 📚

If you’ve so much as dipped a toe in the investing world you know how much jargon there is. Forex is no exception to this rule. So before you really dive into forex trading you need to learn these essential terms:

Pips ➗

Believe it or not, this isn’t referring to a candy or a seed! This term is an acronym, standing for “percentage in points”. It refers to the smallest price changes in a currency pair. 

If you’re familiar with tiny penny stocks this may be more familiar to you – forex prices are quoted out to four or five decimal points, and have very nuanced movements. A pip usually refers to the fourth decimal point, although in currencies with very small denominations (such as Japanese yen) a pip could be within the second decimal point. I know, this section is a bit dense. 

Essentially, when looking at a price of a currency pair, a single pip is 0.0001. For example, if the EUR/USD pair is quoted at 1.2124 and the price goes up to 1.2126, that’s an upward movement of 2 pips. 

Spread 🧈

Nope, this one doesn’t refer to a feast, or the butter you put on your toast. The full term is actually “bid-ask spread”, and it’s very similar to the way stocks work. 

Similar to stocks, the spread refers to the difference between the bidding price that a buyer is willing to pay for a currency, and the ask price that a seller is willing to sell for. That value is the price that the trade will execute at.

Leverage ⚖️

If a forex investor is still daunted by the lot sizes that it takes to execute trades then they can borrow money, i.e. use leverage, to get started. It’s just important to bear in mind that using leverage requires a trader at least deposit a margin upfront before they can borrow.

How this works is—if your broker offers a 100:1 leverage, that means you can control a position that’s up to 100 times larger than your balance. If you have $500 on your account, that means you can make a $50,000 trade.

Forex-Leverage
A leveraged trade has greater buying power.

If you win a highly-leveraged trade, you win 100 times more than you would’ve normally. However, if you lose, your losses are also multiplied—that’s why it’s not recommended to leverage more than a couple percent of your portfolio at once.

Lots 💲

Forex is traded with a standard unit of currency called a “lot”, and it’s… well… a lot. A typical lot consists of 100,000 units of currency! 

Before you start writing forex off as an out-of-reach consideration, though, there are more options. Micro lots (1,000 units) and mini lots (10,000 units) are also options that make the starting threshold a little more attainable.

Volatility 📊

If a price goes up and down a lot, it is considered volatile. An unstable, volatile currency pair is riskier to trade, but also has greater potential to yield profits. This is why risk-averse traders focus on non-volatile currencies, whereas profit-seekers prefer volatile currency pairs.

Forex Quotes Dissected 💱

Every forex quote and trade will consist of a pair of currencies. Each currency pairing has a base currency (the first) and a quote currency (the second). 

Here’s an example:

EUR/USD=1.1051. This is saying that 1 EUR is worth 1.1051 USD. The base currency is always 1. There are two parts to the forex quote: the bid and the ask—first is the price at which you can sell and the latter is the price at which you can buy. 

Forex quote example
An example of a forex quote, using EUR/USD.

For example, the bid may be 1.1051, and the ask may be 1.1053. Forex trades are dealing with small fractions, often 1/100th of the currency, so it will typically be reflected in just the last two digits. 

Spot, Forward, and Futures Forex Markets 👇

Forex markets are very different from the stock exchange. The forex market is managed by a wide network of banks, and is electronically distributed, so it has no central location. 

Regional market hours are based around the peak trading times of major time zones: New York, London, Tokyo, and Sydney, but without a central location it allows forex markets to be open 24 hours/day, Monday through Friday! 

Therefore, the most profitable time to trade forex will depend on which currency pairs you’re trading. The main global exchanges, as well as the forex market as a whole is split into three categories:

1. The spot market – This is the primary market, where currency trades are made in real-time based on supply and demand.

2. The forward market – Trades in the forward market are not executing in real-time, but are actually binding, private, customizable contracts between two traders to lock in an agreed-upon amount for the future. 

3. The futures market – A trade in the futures market is very similar to the forward market, but the contract between traders is standardized, less customizable, and is done through an exchange. 

If you are a beginner in world of currency trading, you will most likely use the spot market. The other options are for more advanced trades that use more speculation, and are often being used to hedge against price changes in the future.

Example of a Forex Trade 💡

Say GBP/USD is trading at 1.3544, with a buy price of 1.3548 and a sell price of 1.3539. This gives it a spread of 9 pips. If you believe the pound will gain value against the dollar you may buy the currency at 1.3548.

As mentioned before, you would typically buy this position in the form of a lot, which is 100,000 units. In this case, this would be like trading £100,000 for $135,480. If you don’t have the 100,000 to spare, you may be using leverage to make the trade. The margin rate of GBP/USD for a retail forex trader is usually 3.33%, so you only have to commit $3,330 out of your pocket.

Let’s say, for our example, that your prediction was correct (because that’s WAY more fun!), and the pound gains against the dollar. Now GBP/USD is trading at 1.3565, with a buy price of 1.3569 and a sell price of 1.3562. You want to close your position so you reverse the trade and take 1.3562. You would now have $135,620, or a profit of $140 ($135,620 – $135,480) for the day. 

Keep in mind, you’ll have to deal with capital gains taxes on your profits, and funding fees if you keep your position overnight. This is why traders usually sell their positions before the end of the trading day—it’s always good to be aware of pesky regulations and taxes before you start counting your earnings.

⚠️ Keep in mind: The markets are often very unpredictable—make sure how to hedge your forex trades just in case of an un expected price shift.

Pros and Cons of Forex Trading 👍👎

So why are you learning all of this? Is forex trading actually worth it? Is it as lucrative as some investors claim? 

Michael Kamerman, writing for Global Banking & Finance Review, says that “a sector experiencing outsized growth in online trading is retail FX and CFD trading” in the COVID-19 landscape, and that the significance of retail forex trading is not just exploding but is here to stay

If this is the case, you may be wondering how to get your piece of the pie. As with any kind of investing, there are major pros and cons, and you should understand both before diving into forex.

Pros: Is Forex Trading Profitable? ✅

In theory, yes. Forex is a highly volatile market, where a currency can jump one day due to good news and drop the next because of a bond selloff or a natural disaster. Similar to other investments that are high risk, forex investing can be very lucrative, and can even outperform stock trading.

This is the case with most volatile forms of trading. Penny stocks are a good example of this. They’re risky because of how wildly they move, but gains on a penny stock can be astronomical in a matter of hours. Forex trading will have similarly drastic movements in short periods of time, and this of course gives you opportunity for BIG jumps in your money’s value.

The second big advantage to forex trading is that a trader can hedge forex to protect themselves from exchange rate fluctuations. Hedging drastically reduces or limits risk, especially in light of the distinct volatility of forex

It will be important to keep an eye on the retail forex market heading into 2021. There’s no doubt about it, 2020 was a bit of a soap opera for investors (and frankly, for everyone else). However, the news seems pleasant—a combination of COVID-19 vaccines and a surge of new traders is likely to boost the forex market even further into the future.

Cons: The Risks of Forex Trading ⚠️

It’s important to note that the majority of non-professional, retail forex traders lose money. Statistics generally agree that about 60%-80% of forex traders end with losses, and even those who made a profit did not necessarily make a viable or meaningful one. Discipline, strict strategies, and unemotional trading are essential for success (but more on that in a bit).

While pursuing the profitability potential in forex is not a bad idea by itself, never keep more than 20% of your investment portfolio in forex. Stay diversified, keep the majority of your funds in less volatile investments, and use forex as a means of small, quick growth as you hone your strategy.

The biggest danger to forex traders is the availability of leverage. It allows traders to use far more money than they actually have to make these trades, but it also opens them up to losing enough to wipe their brokerage balances!

So how do you strategize and become a successful forex trader in spite of the odds? One thing that most traders don’t have is knowledge—learning to trade forex is the essential first step. This market isn’t something you can figure out on the fly, so make sure you see how it works first and use your broker’s demo account to test the water before diving in.

The Bottom Line

The forex market is huge and alive 24/5, which makes it a dream from traders looking for quick execution and endless trading opportunities. Newcomers looking to learn to trade forex can use their broker’s educational resources to get accustomed to this trade, while seasoned experts always have room to improve their strategies. For both, a proper guide to forex trading will be very useful.

However, the biggest bane of forex traders are not the numerous technical terms and complex concepts they have to master. Forex trading is a game for those who have a cool head, even when their money is on the line. All in all, making good money with forex is not hard to do once or twice—but only experts can do it consistently and keep their risks, and therefore losses to a minimum.

What is Forex Trading: FAQs

  • Can You Get Rich by Trading Forex?

    The amount of money you can make in forex is based on your invested capital and the level of risk you’re willing to take on. Naturally, high risk means you will lose a lot of money eventually, so the usual way to earn a lot through forex is to make slow steady gains. Eventually, your daily profits can reach 4 digits or more if you have enough skill and capital, but that might require many years.

  • How Do I Start Trading Forex?

    To get started, open an account with a forex broker and deposit the funds you want to trade with. Then, you can practice with your broker’s demo account, and when you think you’re ready, trade with real money via your broker’s free trading platform.

  • Why is Forex a Bad Idea?

    Trading forex might be a bad financial move because all the profits go to the minority of traders who are often very disciplined, proficient, and averse to risk. Statistics generally agree that more than 60% of forex traders lose money and much of that comes from new traders who are overleveraged and accrue huge losses early on in their career. 

  • Can You Live Off of Forex Trading?

    Not if you are a new trader, but many people day trade forex professionally. However, the level of skill and capital investment you need to make a good living is not something that can be gained quickly and easily.

Get Started with a Forex Broker

Fees
Average spread EUR/USD standard

0.9

N/A

All-in cost EUR/USD - active

0.363

N/A

Minimum initial deposit

$250

$0

General
Total currency pairs

93

105

Demo account?
Social / copy trading?
Rating
Fees
Average spread EUR/USD standard

N/A

1.13

All-in cost EUR/USD - active

N/A

0.86

Minimum initial deposit

$0

$200.00

General
Total currency pairs

105

59

Demo account?
Social / copy trading?
Rating
Fees

Average spread EUR/USD standard

0.9

N/A

1.13

All-in cost EUR/USD - active

0.363

N/A

0.86

Minimum initial deposit

$250

$0

$200.00

General

Total currency pairs

93

105

59

Demo account?

Social / copy trading?

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Cookies & Privacy

The Tokenist uses cookies to provide you with a great experience and enables you to enjoy all the functionality of the site.