How The Forex Market Works

Forex Market Explained

The Foreign Exchange Market (forex) is the world’s largest financial market with daily trading volume exceeding trillions of dollars. The forex market includes the trading between large banks, central banks, currency spectators, multinational corporations, governments, and other financial markets and institutions.

How does the Forex Market work?

Forex trading involves trading of a single currency for another currency at a decided trade price on the over-the-counter (OTC) marketplace.

How The Forex Market Works
How The Forex Market Works

Each currency is commonly given a three-letter symbol (e.g. USD) and are traded in pairs such as the EURUSD, GBPUSD, USDJPY, etc. A currency pair usually depicts a quotation of the two different currencies, for example, EURUSD describes the Euro and United States Dollars. The first currency, in this case, the Euro is referred to as the base currency whilst the second currency which in this case is the United States Dollars is referred to as the counter currency or quote currency.

Forex Currency Pairs
Forex Currency Pairs

When you trade forex, you are buying one currency and selling another. If a trader was to buy the EURUSD, it would mean that they are buying the Euro whilst simultaneously selling the United States Dollar. Likewise, if they were selling the EURUSD it would mean that they are selling the Euro whilst buying the United States Dollar.

If a currency quote was to show the EURUSD at 1.20, this means that to purchase one Euro, the trader would require 1.20 United States Dollars. If the quote moved from 1.20 to 1.25, it would suggest that that the Euro is getting stronger whilst the United States Dollar is getting weaker and depreciating. On the contrary, if the quote moved from 1.20 to 1.15, it means that the Euro is getting weaker whilst the United States Dollar is getting stronger.

A currency quote can consist of two prices known as the bid price and ask price. The bid price shows the maximum price at which a buyer is willing to pay for a particular currency whilst the asking price is the minimum price at which a seller is ready to accept for a currency.

The difference between the bid and ask price is known as the spread. This is a fee that that most brokers will charge if you want to buy and sell currencies. I tend to find that ECN forex brokers can have some of the tightest spreads which can help me to save on my trading costs in the long term.

Forex Currency Prices
Forex Currency Prices

There are a variety of key factors which impact the value of currencies and can cause currency pairs to increase or decrease in value. These include political and economic factors which is why fundamental analysis is considered an important aspect of forex trading.

Forex traders try to make a profit by speculating on the price of currency pairs. They look to take advantage of fluctuations in the value of one foreign currency to another by actively speculating on which way foreign exchange rates are likely to turn in the future.

This is usually done through technical analysis using charts and indicators, fundamental analysis by tracking news releases, price action analysis and sentiment analysis. If a forex trader believes a currency pair will rise then they would look to place a buy (long) position. If they anticipated that the currency pair may fall, they would look to place a sell (short) position.

Forex Market Summary

The core difference between the forex market and other financial markets is that forex is a decentralized market because there is no one physical location where investors go to buy and sell currencies.

Forex is an over the counter market that does not have any physical form and the trading usually takes place 24 hours a day, 5 days a week. This makes it an attractive proposition for retail traders as there are various trading sessions whilst the currency rates keep appreciating and depreciating towards one another.

If you are new to trading forex, you may wish to start with a demo trading account in order to familiarize yourself with how it works. You can open a demo account with a forex broker and download a forex trading platform to get started.

I have written a few simple guides on how to open a forex account and how to trade forex that you may find useful.