What is Forex Trading

The forex market is the largest financial market in the world. The volumes traded here are staggeringly high with trillions of dollars being recorded in daily trades. Currencies of various countries are traded in this market which is active 24 hours a day.

The change in values of these currencies with respect to the base currency is the basis of forex trade. The US dollar holds a special place in this market and is the most traded currency because of its acceptance as the global reserve.

The Forex market is dominated by large players like banks, investment companies and other organizations, but the individual investor is not completely excluded. This market has some unique features which make it as accessible to the small investor as the large financial institution.

The forex market and the manner in which trading was done in it underwent a massive transformation with the advent of computerization and the World Wide Web. As a consequence of these developments, it has now emerged as a competitive marketplace for investors of all sizes.

Investors looking to make spectacular gains possible with forex trades must keep themselves in the know about the many factors which affect the market. Assimilating the right kind of information is the first step to successful forex trading.

Table of Contents
Chapter 1: What is Forex Trading
Chapter 2: History of Money and Origins of Forex Trading
Chapter 3: Forex Trading Terminology
Chapter 4: Important Aspects of Forex Trading
Chapter 5: Players in The Forex Market
Chapter 6: Factors that Affect the Forex Market
Chapter 7: Risks Involved With Trading Forex
Chapter 8: Why Trade in the Forex Market
Chapter 9: How Forex Trading Works
Chapter 10: How to be a Successful Forex Trader

Navigate This Page
Chapter 1: What is Forex Trading
- How the Forex Market Works
- Understanding the Trading Process
- Selling and Buying
- Bid and Ask
- Yen in Special Cases

Chapter 1: What is Forex Trading

Forex trading is an investment technique aimed at making gains from the changing values of currencies across the world. To make a profit, the currency of one country will need to be set off against another which is used as a base currency. Currency pairs are used to represent a forex trade to show the two currencies which are being weighed against each other.

A currency pair represented as USD/ JPY stands for US dollars and Japanese yen. Here the USD is the base currency while the Yen is the counter currency. The USD is being traded against the Yen in this currency pair.

In a forex transaction, the actual currency is almost never exchanged. The deals are undertaken as contract between two parties, and the gains or losses are recorded into the trader’s account.

There is enormous volatility in currency values throughout the day. Although the actual price fluctuation may not be drastic all the time, there is constant movement in either direction. An astute trader can make significant gains if he learns to react correctly to the markets.

How the Forex Market Works

The forex market is relatively free from regulation when compared with other markets like a stock exchange. A trade is directly entered into by the two interested parties. There is no need for an intermediary through which the transaction should always be routed, though there are many facilitators who take the role of intermediaries for small investors. There is no clearing house to settle dues.

The forex deals do not take place in an exchange but over the counter or OTC. This underlines the need for the participants to be highly disciplined in trading.

An individual investor can trade via a forex dealer in the OTC market. Dealers register with the National Futures Association to add to their credibility. Registered members can call for arbitration by the NFA in case of disputes in any transactions.

Understanding the Trading Process

Forex trading can be confusing for a novice trader, but with some knowledge and practice, it will get become much easier. The first step to understanding forex trading is to understand how prices are quoted. Consider the currency pair of USD/ JPY. In a quote, the currency pair will read like this:

USD/JPY= 118.20

This shows that every US dollar is worth 118.20 yen. Or if you wanted to buy one US dollar with Japanese currency you would need to pay 118.20 yen.

If a forex trader believes that the Yen will fall in value, he can sell yens to buy the base currency – US dollars. Buying the base currency gives him a long position on the trade. Similarly, if he believes that the Yen will improve in value against the dollar to, say, 120 yen to a dollar, the trader can buy Yen and sell dollars. When he sells dollars, his base currency, he is adopting a short position on the trade.

Selling and Buying: In forex trades, it is important to understand what selling and buying a currency pair actually represents. In our currency pair, ‘buying’ means purchasing dollars in exchange for yens while ‘selling’ means, paying for yens with dollars.

Bid and Ask: Every transaction needs a buyer and a seller. Similarly, every transaction needs a sale price and a purchase price. In forex trade, these are called bid and ask. The bid price is the price that you will get from the market if you sell your base currency and the ask price is what you can buy the same currency from the market for. As there is no exchange, it is the dealer who will be quoting bid or ask prices for your currency pair.

A quote containing the bid and ask prices for our currency pair will look like this:

USD/JPY = 118.20/25

The 118.20 which is to the left of the slash is the bid price or the price at which you can sell your dollars to the dealer. If you want to buy dollars, you will need to pay 118.25 (the figure to the right of the slash) to the dealer. The dealer makes his gains by selling at the higher rate and buying at the lower rate.

Yen as a Special Case: Yen is a special case when used as a counter currency in forex trades. It is the only currency whose exchange value is shown with just two decimals. All other currencies are shown with four decimal places. For example:

EUR/ USD = 1.5500 (i.e. 1 Euro can buy 1.5500 US dollars)

A bid / ask quote for this currency pair may look like this:

EUR/ USD = 1.5500/05 (i.e. bid price for euro is 1.5500 and ask price for Euro is 1.5505)

Note that in this example the base currency is the euro. If the trader feels that the dollar’s value will decline when compared with the euro then he will buy Euros with his dollars (take a long position). Conversely, if he feels that the value of the dollar will rise he will short – sell euros to buy dollars.

Next Chapter: History of Money and Origins of Forex Trading