What is Forex? Understanding Forex Trading

Table of Contents

What is Forex?

The short answer is "Forex is global market that allows anyone to trade between two currencies against each other at any point in time". The foreign exchange market, popularly called forex (FX) for short, is the world largest decentralized market place that facilitates the buying and selling of different currencies at a constantly changing exchange rates. This process often happens over the counter (OTC) via the interbank market instead of a centralized exchange which thus makes the market fully decentralized.

Almost (if not) everyone has participated in the forex market knowingly or unknowingly, a typical example, if you are living in Georgia and want to buy cheese from France, either you or the company making the sales of the cheese has to pay the French for the cheese in euros (EUR). This means that the Georgian importer would have to exchange the equivalent value of Georgian Lari (GEL) into euros. Similar case can be found in traveling. Assuming a tourist from Germany intends to see some artifacts in a local museum in South Africa, the tourist will not be able to pay for the entry tickets with his Euros and as such, the tourist has to exchange the euros for the local South African currency, in this case the South African Rand, at the current exchange rate, these processes and exchanges are what we referred to as forex however in its simplest form.

A lot of people both Traders and Wannabe-traders are drawn to forex for various reasons, amongst which are:

- The size of the Forex market

- Availability of a wide range of currencies to trade

- High volatility (increased market movement)

- Low transaction costs

- 24/5 non stop trading opportunity

- No taxes

Before we get too deep in details on  how you too can take advantage of these exciting benefits lets quickly learn a short historical background of the forex market, at the end of this article you'd not only want to be a trader but you'd realize you've been born to be a trader. Ha! Ha! Ha! 

A Brief history of forex (FX)

Its unfair to say the forex market is a baby market considering the fact that from the age of time humans have been converting one currency to another for financial gains, thus we could say forex had begun since nations started minting currencies. However, forex as you and I know today only started few years back unlike its counterpart the stock market which had begun for centuries the forex market is barely 80 years old as at the time writing.

It all started toward the end of the World War II in 1944, the entire world was encountering so much disarray that the significant Western governments wanted to make a framework to settle the worldwide economy. This framework was known as the "Bretton Woods System", at the end of the conference an accord was reached which thus set the swapping scale of the US dollar against gold and this permitted every other money to be pegged against US dollar. Bretton Woods System

For a period of time, this agreement had maintained a fair exchange rate amongst the countries, but this could not be sustained for long due to the limitations and restrictions of the system and as some countries began to develop faster than others, come 1971, the Bretton Woods Agreement was annulled and supplanted by an alternate money valuation framework after which more major currencies were allowed to float freely against one another.

The new system had been structured to determine the value of currencies based on the demand and supply of it. From the start, it was hard to decide reasonable trade rates but as the world began to develop and technological advances, things became much easier over time.

Who would have thought the 8th greatest wonder of the world would have happened just after the WW II, "The Internet" - Nicholas Ilechie

Soon as the internet came along in the early 90's banks began to make their own trading platform, these platforms were intended to stream live price quotes to their clients with the goal that they could in a split second execute exchanges themselves. For a while the banks where the only institution benefiting from the forex trades and thus forex was only for the big guys or the very wealthy, this as well wasn't for long as some very intelligent entrepreneurs developed  new trading systems which was internet-based trading platforms for individual traders.

These smart-ass entrepreneurs are what we now refer to as “retail forex brokers”, they made it easy for individuals to trade by allowing smaller trade sizes.

With the retail brokers, individuals could take trades as little as 1000units (equivalent to 0.01lot) compared to the banks which had only permitted a minimum of a million unit( equivalent to 10lots, that is to say in today's world you would have needed at least $100,000 back then to have participated. Just on a side-note a hundred thousand dollars as at the late 90's and early 2000 had same value of a million dollar today) so once again thanks to those geniuses if not we probably wouldn't even be having this discussion today, haha!

Understanding Forex Trading

More or less, the foreign exchange market works like most other markets in that it is subject to demand and supply. Trading forex involves the buying of one currency and simultaneous selling of another. In forex, traders attempt to profit by buying and selling currencies by actively speculating on the direction currencies are likely to take in the future. Using a typical example, if there is a strong demand for the US Dollar from European citizens holding Euros, they will exchange their Euros into Dollars. The value of the US Dollar will rise while the value of the Euro will fall. Remember that this exchange just influences the EUR/USD currency pair and won't for instance, cause the USD to deteriorate against the Japanese Yen.

 

Why is The Forex Market So Popular?

Most likely, you must have heard the forex market is the largest financial market in the world, we literally mean that. To the forex market every other market feels like little dwarfs perhaps even peanuts 🥱.. The massiveness of the foreign exchange market is enough reason to make it very attractive and popular however there are more exciting benefits that the forex market possesses.

Due to the fact that the foreign exchange market allows large institutions, governments, retail traders and private individuals to exchange one currency for another uninterruptedly even in times of war or heavy disasters the liquidity of the market gains so much enormous trading volume compared to any other market. Just incase you don't know as at the time of writing the forex market runs an average of $6.6 Trillion Dollars daily trading volume, not sure you got that right please allow me repeat, $6.6 TRILLION DOLLARS AVERAGE DAILY TRADING VOLUME that's with a "T" as famous as the stock market it only has about $23 billion dollars avg trading volume and the crypto currency market, well lets leave the babies to grow. This liquidity enables trader to be able to enter and exit trades at any point in time.

Aside the liquidity of the forex market the benefit of having forex trade between global banks making it possible for forex to be traded around the clock (during the week). As the trading session in Asia comes to an end, the European and UK banks come online before handing over to the US. The full trading day ends when the US session leads into the Asian session for the following day.

What is forex trading and how to make profit from forex?

Taking away all the complexities involved in trading, at the center of it all, Forex trading is all about speculation regarding which currencies will rise and which will fall. If you have a strong believe that the pounds is going to decrease in value against the dollar this conviction could be as a result of the Brexit transition or economic tension or perhaps other reasons you see fit, you would sell pounds and buy dollars this is also referred to as going "short" on the pounds.

You would ideally like to close the position at a price point that is lower, in order to generate a profit. Conversely, if the pounds is expected to increase in value against the dollar, you would buy pounds and sell dollars. You will make money if your prediction is correct.

This is basically the skeleton of forex trading, traders will also need some skills and tools, to professionally analyze the market and know the directions. If you'd like to become a professional trader NFX offers a premium mentorship service where we train you to perfectly understand how to read the charts, analyze the market and interpret the news, you can opt in for our mentorship at any point in time or take some of our courses.

Who can trade the forex market?

In a clear sense, literally any one with basic understanding of money and economy can trade the forex market, irrespective of being a doctor, singer, artist banker, student whatsoever and as the world is constantly globalizing and technology rapidly increasing it would also be fair to say about 70% of the world population trades forex consciously or subconsciously. Professionally we can categorize the entire forex traders into two: 

A. The Hedgers

B. The Speculators

The hedgers are those who love to play safe and avoid high risks in the market such are usually the big banks, multinational company like shell, exxon, microsoft etc and also government agencies and institutions, on the other hand the speculators are often the more active traders however they fill up the lower percentage of the trading volume, they are the risk seekers who are always looking for volatility in exchange rates to take advantage of, the majorities in this category are the retail traders like yourself, banks, dealing desks brokers, investment and hedge funds companies, etc.

Helpful Tips: Reading a Forex Quote

It is necessary for all traders need to understand how to read a forex quote as this is will determine the price you enter and exit the trade. Using the example below the first currency in the GBP/USD pair is known as the base currency, which is the Pounds, while the second currency in this pair (USD)is known as the variable or quote currency which is the Dollar.

For most FX markets, prices are offered up to five decimals but the first four are the most important. The number to the left of the decimal point indicates one unit of the variable currency, in this example, it is the GBP and therefore is £1. The following two digits are the pence, so in this case 25 US cents. The third and fourth digits represent fractions of a cent and are referred to as pips.

When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy ONE unit of the base currency. In the example above, you have to pay 1.25990 U.S. dollars to buy 1 British pound.

When selling, the exchange rate tells you how many units of the quote currency you get for selling ONE unit of the base currency. Using same example above, you will receive 1.25990 U.S. dollars when you sell 1 British pound.

The base currency represents how much of the quote currency is needed for you to get one unit of the base currency, If you buy GBP/USD this simply means that you are buying the base currency and simultaneously selling the quote currency.

It’s key to note that the number in the fourth decimal place is known as a ‘pip’. Should the EUR depreciate against the USD by 100 pips, the new sell price will reflect the lower price of 1.25990 as it will cost less in USD to buy 1 GBP.

Why trade forex

If you've been paying attention from the beginning of this article no doubt you must have already seen so many benefits the forex market possesses, for the sake of this article we will narrow down some of the top benefits of trading forex, however, there are also countless of other benefits.

1. No commissions: The fact that trading forex comes with no clearing fees, no exchange fees, no government fees, no brokerage fees makes it more welcoming than equities or stocks which have some commission charges. Generally retail brokers are compensated through a term called "spread"

2. No middlemen: Forex trading requires no intermediaries or middle men as it allows you to trade directly with the market responsible for the pricing on a particular currency pair. Forex brokers should not be mistaken as middlemen as they only provide you access to the trading network and nothing else, you are fully responsible for every thing you with your trading account.

3. Low transaction costs/spread: The retail transaction cost (the bid/ask spread) is typically less than 0.1% under normal market conditions. Bid/Ask spreads are extremely low for major FX pairs due to their liquidity. When trading, the spread is the initial hurdle that needs to be overcome when the market moves in your favor. Any additional pips that move in your favor is pure profit.

4. 24-Hour market: There is no waiting for the opening bell. From the Monday morning opening in Australia to the afternoon close in New York, the forex market never sleeps. This is awesome for those who want to trade on a part-time basis, because you can choose when you want to trade: morning, noon, night, during breakfast, or in your sleep.

5. Decentralized market: The foreign exchange market is so huge and has so many participants that no single entity (not even a central bank or the POTUS Donald Trump himself) can control the market price for an extended period of time.

6. Leverage: In forex trading, a small deposit can control a much larger total contract value. Leverage gives the trader the ability to make nice profits, and at the same time keep risk capital to a minimum.
For example, a forex broker may offer 50-to-1 leverage, which means that a $50 dollar margin deposit would enable a trader to buy or sell $2,500 worth of currencies. Similarly, with $500 dollars, one could trade with $25,000 dollars and so on. While this is all gravy, let’s remember that leverage is a double-edged sword. Without proper risk management, this high degree of leverage can lead to large losses as well as gains.

7. High Liquidity: Recall earlier when we mentioned the forex market has over $6.6 trillion dollars average trading volume daily? this is what we refer to as liquidity, This is an advantage because it means that under normal market conditions, with a click of a mouse you can instantaneously buy and sell at will as there will usually be someone in the market willing to take the other side of your trade. You are never “stuck” in a trade. You can even set your online trading platform to automatically close your position once your desired profit level (a limit order) has been reached, and/or close a trade if a trade is going against you (a stop loss order).

8. Little or No Restrictions: Provided you above the legal age in your country, you can create a forex account with a brokerage firm and start trading, theres no age limit, gender biases, country restrictions, racial prejudices or special degree or certificates needed, anyone and absolutely anyone can become a trader.

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