Forex trading: what is it & how does it work?

What is forex trading? How does forex trading work? It’s the buying and selling of foreign currencies – the word “forex” means foreign exchange. The idea is to convert one foreign currency into another in the speculation that changes in the exchange rate between the two currencies will mean that the conversion generates a profit.

The forex market or currency market is the largest market in the world. Every day, seven trillion American dollars worth of money changes hands. That’s equivalent to $1,000 for every single person on earth. 

How does forex trading work?

If you’ve ever gone on vacation abroad, you may have already done some forex trading without even realizing it. Here’s a really simple example.

You’re going on vacation to Australia next month. You want to take ten thousand American dollars worth of Australian dollars with you. The bank gives you an exchange rate of 1.38, which means that one US dollar (USD) is worth 1.38 Australian dollars (AUD).

The exchange rate is simply the value of one currency in comparison to another.

This means that your 10,000 American dollars can buy you 13,800 Australian dollars.

However, there’s a problem, and your vacation is postponed. You figure that it makes more sense for you to have US dollars while you’re in America, so you go to your bank and convert the Australian dollars back into US dollars.

The exchange rate has changed since the initial conversion. One US dollar is now worth 1.37 Australian dollars. This means you’ll get 1 US dollar for every 1.37 of your Australian dollars.

13,800 divided by 1.37 is 10,072, so the bank gives you $10,072. The change in the exchange rate means you made $72.

Forex trading pairs

A currency conversion obviously involves two currencies. We refer to these two currencies together as a pair.

USD/CAD, or the American dollar against the Canadian dollar, is a pair. So too is GBP/USD, the British pound against the American dollar.

It doesn’t matter whether the pair is written as USD/CAD, USD-CAD, or USDCAD. They all refer to the same thing.

In a currency pair, the first currency is known as the base currency. The second currency is known as the quote currency.

Types of pair

There are several different types of currency pairs.

Major pairs

Major forex pairs represent some of the most commonly traded currencies in the world. All major pairs involve the US dollar or USD.

Here are the seven major forex pairs:

Currency pair Currencies Nickname
AUD/USD Australian Dollar / US Dollar “Aussie dollar”
EUR/USD Euro / US Dollar “Euro dollar”
GBP/USD British Pound / US Dollar “Pound dollar”
NZD/USD New Zealand Dollar / US Dollar “Kiwi dollar”
USD/CAD US Dollar / Canadian Dollar “Dollar loonie”
USD/CHF US Dollar / Swiss Franc “Dollar swissy”
USD/JPY US Dollar / Japanese Yen “Dollar yen”

Minor forex pairs

In forex trading, a minor pair consists of two major pair currencies. These currencies can be any two, but not the US dollar. For example, GBP/CHF, or AUD/JPY are minor pairs.

Minor pairs are also known as cross-currency pairs.

Exotic pairs

An exotic pair consists of any one of the currencies from the major pairs, including the US dollar, and a currency from a developing economy, such as the US dollar against the South African Rand (USD/ZAR), or the Euro against the Brazillian Real (EUR/BRL).

Forex trading pips

So now you understand the principle of FX trading, let’s look a bit closer at the numbers behind it.

Using the Australian vacation example above, we mentioned that 1 American dollar is 1.38 Australian dollars.

However, in forex trading, we measure changes to the exchange rate with much finer divisions than just cents. This typically involves five numbers after the decimal point.

For example, at the time of writing, the USD to AUD exchange rate is actually 1.38470.

These finer divisions are called pips

Generally speaking, there are one hundred pips in a cent or a penny, and an easy way to count them is to look at the two numbers after the “cents”.

So for example, an increase of 1.38472 to 1.38472 to 1.38512 is an increase of four pips.

And that final number on the end, the fifth digit after the decimal place, is a pipette. There are ten pipettes in a pip.

Once you get your head around them, pips aren’t difficult to follow at all. After all, when you count in dollars and cents, you’re already counting in a base 10 system, so counting pips is kind of like an extension of this. There are a hundred cents in a dollar, and a hundred pips in a cent. Simple.

There are a couple of exceptions to this rule involving other currencies – an obvious example is the Japanese Yen. We’ll cover that in a separate post.

Trade sizing

Using the Australia vacation example again, let’s say that the exchange rate changed from 1.38470 to 1.38670.

This is a difference of 20 pips – a fifth of a cent.

Obviously, a fifth of a cent isn’t really a great deal of money. This change in the exchange rate on a $10,000 trade would’ve netted a grand total of $14. That’s certainly nice to have, but not really much to shout about.

Nevertheless, the concept of making money is there, and in order to take advantage of those small changes and maximize your profits, the obvious thing to do is to trade with larger sums of money.

In forex trading, the size of trades is measured along that principle. We don’t count the size of trades in thousands or tens of thousands of dollars or pounds or Euros, but in lots.

One lot is 100,000 units of the base currency. It doesn’t matter what the base currency is.

So, a 1 lot trade of EUR/USD is 100,000 Euros worth of American dollars. A 1 lot trade of GBP/CAD is 100,000 British pounds worth of Canadian dollars. And a 10 lot trade of GBP/CAD is a million pounds worth of Canadian dollars. There’s much more info on this topic on the lot sizing page.

Forex trading leverage

We know what you’re thinking at this point. The average beginner forex trader simply does not have six figures worth of free cash for trading.

This is where a concept called leverage comes in.

It allows you to place trades with much more money than you actually have, so you can take advantage of those small changes in the exchange rate.

Leverage is usually expressed as a ratio. So for example, if the leverage on your forex trading account is 1:100, then this means that you can place a 1 lot trade of USDCAD with only 1,000 USD. The remaining 99,000 USD isn’t a loan or a credit – your broker simply assigns it to the trade while the trade is open.

The amount of money that you use in order to place a leveraged trade is known as the margin.

You should note that you also need a certain amount of money in your account which is not used as margin for the trade or indeed any other trades you may have running.

This money is known as the free margin.

Losing money

If you were to look up the phrase “double-edged sword” in a dictionary, it wouldn’t surprise us to find leverage as an example.

Just as leverage will magnify your gains, so too will it magnify your losses if the exchange rate changes against you.

Forex trading and trading leveraged products is very risky. You should never trade with money that you can’t afford to lose.

Forex trading risk management

For this reason, arguably the most important concept in the whole business of FX trading is good risk management.

In forex trading, it’s impossible to get rid of risk completely. That’s why it’s called risk management because the only unconditional way not to put your money at any risk is not to trade in the first place.

No forex trader wins every single trade, and at some point, they will experience a string of losses.

Good risk management means that you can absorb these losses without incurring too much overall loss to your trading capital. Because your capital is pretty much the most important thing – without it, you can’t trade.

Effective risk management means that, even after a string of losses, your head will still be above water, and you won’t have lost so much money that it’s then really difficult or time-consuming to build your account back up again.

Generally speaking, you should never risk more than 1-2% of your account balance per trade.