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What is Forex Trading?

With a turnover exceeding $5.3 trillion per day, Forex is the world's most traded market. Forex trading is a special type of trade that involves exchanging one currency for another at an agreed exchange rate, usually over-the-counter (OTC). Essentially, forex trading involves simultaneously buying one currency while selling another. Forex traders trade with an aim to profit from currency fluctuations that are caused by a variety of factors including economic and geopolitical ones.

Unlike other financial markets such as stocks and derivatives, Forex trading is done over-the-counter with no central exchanges or a physical location. As such, Forex trading takes place round-the-clock on a 24-hour basis. Forex involves a global network of individuals, businesses, and banks. The constant fluctuations in currency values relative to each other create multiple trading opportunities that traders can take advantage of.

Basic premise of Forex trading

The activity and movement in Forex markets is entirely dependent on the expectations of traders. Before placing an order, a trader will try and figure whether a particular currency will strengthen or weaken against another currency in the future. This will determine how to trade the currency pair i.e. whether to buy or sell.

There are many factors that affect future movements of a nation's currency including the political climate, economic events and announcements, natural disasters, and environmental factors. For instance, let's assume a trader thinks that the U.S. economy will weaken against the British economy. In such a scenario, the trader can sell U.S. dollars and buy Sterling Pounds. If the trader's prediction turns out to be accurate and the U.S. economy weakens relative to the British economy, the dollar is likely to fall in value relative to the pound. The trader can then close their trade by reversing the original trade i.e. selling GBPs back into USD and realizing a profit.

What makes Forex trading quite intriguing for traders is the degree of analysis required when forecasting currency movements. Traders typically try to stay on top of news and events from around the world while at the same time employing charting and analytical tools to predict these price movements.

Best trading times

The fact that trading takes place throughout the day minimizes price gapping (price changes with no trading activity) which allows traders to take positions at any time of day.

It's, however, important to note that although Forex markets around the world are available for trading 24 hours a day and 7 days a week, the best time to trade is when the markets are most active and trade volume is high. These periods of high activity occur when market sessions overlap i.e. when two sessions are open at the same time.

Below are the four main Forex trading sessions in major global markets:

Time Zone (Summer) EDT GMT Time Zone (Winter) EDT GMT
Sydney Open 6:00 PM 10:00 PM Sydney Open 4:00 PM 9:00 PM
Sydney Close 3:00 AM 7:00 AM Sydney Close 1:00 AM 6:00 AM
Tokyo Open 7:00 PM 11:00 PM Tokyo Open 6:00 PM 11:00 PM
Tokyo Close 4:00 AM 8:00 AM Tokyo Close 3:00 AM 8:00 AM
London Open 3:00 AM 7:00 AM London Open 3:00 AM 8:00 AM
London Close 12:00 PM 4:00 PM London Close 12:00 PM 5:00 PM
New York Open 8:00 AM 12:00 PM New York Open 8:00 AM 1:00 PM
New York Close 5:00 PM 9:00 PM New York Close 5:00 PM 10:00 PM


Pricing and leverage

All Forex is quoted in terms of one currency relative to another currency. Each currency pair has a base and a counter currency. The base currency is the currency quoted on the left while the counter currency is quoted on the right. For example, in EUR/USD currency pair, EUR is the base currency while USD is the counter currency. If the price of EUR/USD rises, it means the Euro is appreciating while the dollar is depreciating.

When trading Forex, you should buy a currency pair if you believe the base currency will strengthen relative to the counter currency. In the same token, you should sell a currency pair if you believe the base currency will weaken relative the counter currency.

The four major currency pairs in Forex include:

  • EUR/USD
  • USD/JPY
  • GBP/USD
  • USD/CHF

Currency pairs are quoted to 4 decimal places, with a price change from the 4th decimal place (0.0001) referred to as a ''pip''(price interest point). Yen-based currency pairs are an exception to this rule since they are displayed to two decimal places only, hence a pip = 0.01.

The difference in the Bid/Ask price is referred to as the spread. Spreads tend to widen during times of impending news and events such as central bank meetings and inflation/economic reports. Once the market absorbs the news the spread tends to snap back to normal levels. To illustrate how pips are used to calculate profit or loss in Forex, let's assume that has opened a $300,000 trade for USD/CAD and the pair closes at 1.0568 after gaining 20 pips.

To determine the number of Canadian Dollars that each pip represents, we multiply the amount of trade by 1 pip as follows:

300,000 x 0.0001= 30 CAD per pip

To determine the number of US Dollars that each pip represents, we divide the number of Canadian Dollars by the closing exchange rate as follows:

30 ÷ 1.0568 = 28.39 USD per pip

To determine the trader's profit, we multiply the number of pips gained by the value of each pip in USD as follows:

20 x 28.39 = $567.80 USD profit

Forex is a leveraged product, which means that the trader is only required to deposit a small percentage of the full value of the position. Leverage is a loan provided to a trader by a broker. In fact, the leverage that can be achieved in Forex is actually the highest in the financial market with brokers offering leverage of 50:1, 100:1, 200:1 and even 500:1. If you trade a $100,000 with a margin of 1% (100:1), you only have to deposit $1,000 in your margin account. Generally, more leverage is provided for smaller accounts of less than $50,000 while bigger accounts are less leveraged. The leverage provided in Forex is much higher than the typical 2:1 leverage provided by equity brokers and 15:1 for futures. This large leverage is made possible by the fact currency pairs do not fluctuate as much as equities and futures do, with typical intraday currency value changes being less than 1%.

The effect of using leverage is that the potential profit or loss from a trade can be significantly higher than the capital outlay. Traders can use stop and limit orders to minimize their potential losses.