Forex trading, also known as foreign exchange, refers to the transfer of currency between a network of buyers and sellers at an agreed price. Forex trading is how companies, banks, and even individuals exchange one currency into another. For example, a person traveling from the United States of America to Europe may have needs to convert the US dollars into Euros.
However, forex trading does not necessarily involve the conversion of currency for practical purposes only. Many people are engaged in forex trading to make profits. The more significant chances of making profits attributed to currency volatility are what makes forex trading attractive.
This beginner’s guide to forex trading will look at how the currency markets and forex trading work.
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The Currency Market and How it Works
In forex trading, there are three types of the currency market
- Spot currency market; In the spot forex market, physical exchanges of a currency pair usually occur at the exact point where the trade is settled.
- Forward currency market; Here, both parties agree on a contract to buy or sell a certain amount of currency at a definite future date.
- Future currency market; In this future currency market, a contract is usually agreed to buy or sell a particular currency at a certain amount in the future. The date for buying or selling is not definite here as it is in the forward forex market. Also, the contracts agreed upon in the future forex market are usually legally binding.
To further help you understand how the currency market works, we will now look at the essential terms that you are likely to encounter in your trading.
Base and Quote Currency
The first currency to be listed in a forex pair is usually referred to as the base currency, while the second currency is generally referred to as the quote currency. As explained in the introductory paragraph above, forex trading always involves selling one currency and the purchase of another. The price of a forex pair is determined by how much a single unit of the base currency is worth in the quote currency.
An example of a base and quote currency is GBP/USD, where the GBP is the base currency, while the USD is the quote currency.
Since the currency market involves the transaction and exchange of currencies from all over the world, several factors contribute to how the price of these currencies move. Some of these factors include forces of demand and supply, news reports, central banks, credit ratings, market sentiments, and economic data.
With the understanding of how the currency market works, we will now look at how forex trading works.
Forex Trading and How it Works
Although trading forex involves the simultaneous buying and selling of currency, there are various ways in which you can trade forex. Contrary to before, where you had to do transactions through a forex broker, today, one can take advantage of the online trading platforms such as Mt4 and Mt5.
Some of the main terms that you are likely to encounter while trading forex include;
The spread can be defined as the variation between the buy and sell prices that are quoted for a particular currency pair.
Lots are batches of currency that are used to regulate forex trades. An average lot is usually 100,000 units of the base currency. This leads to almost all currency trading to be leveraged since individual traders cannot have 100,000 of the base currency they want to place on each trade.
Leverage is the means through which an individual trader gains exposure to vast amounts of money without necessarily having to pay the full worth of his trade upfront. An individual trader can deposit a small amount of currency, which is known as a margin. Profits or losses are usually based on the trade’s full size after an individual trader closes a leveraged position.
There are other terms in forex trading, such as margin and a pip. Novice traders need to familiarize themselves with these terms for effective forex trading.