What is forex trading and how does it work?

08 September 2021 | Posted by Frankie Jones

If the term ‘forex’ brings to mind a floor of traders furiously watching screens filled with confusing graphs and numbers, you’re not alone! We’re here to demystify forex trading so you can be clear about the risks and rewards.

What is forex trading?

Forex trading (also referred to as foreign exchange or FX trading) is a type of investing. Before you read on, it might help to get a basic understanding of why we invest in the first place.

FX trading is basically the conversion of one currency into another. In fact, it’s the most-traded financial market in the world.

The foreign exchange market determines foreign exchange rates for every currency, from the Dollar to the Yen and everything in between. All aspects of buying, selling and exchanging currencies happen here.

The forex market is open 24/7 – the fact that you can potentially make money at any time of day or night is one of the reasons forex is so attractive to investors. There are also very few barriers to trading forex, which makes it appealing for beginner investors.

How does it work?

Forex trading takes advantage of the fluctuations in currency exchange rates. You’re not setting a currency’s value, but determining its value relative to another.

For instance, you might bet on the value of the Pound in relation to the Euro, or vice versa.

Traders speculate on forex pairs (e.g. the USD/GBP pair) to profit from one currency strengthening or weakening against another. If the price of a pair is rising, it means that the base is strengthening against the quote. When the price is falling, that means the base is weakening against the quote.

The key factors that affect the market are:

  1. Central banks – They ultimately control the supply and demand of money in an economy
  1. News reports – Both bad and good news about a certain region can discourage or encourage investment into that currency
  1. Market sentiment – Usually based on the news, if people believe a currency is heading one way, they will invest accordingly

Forex trading is mainly done by big corporations, but everyday investors can get involved too.

Is forex trading for beginners?

There’s a big difference between trading and investing

Forex trading is about buying and selling for short-term gains, whereas investing is about putting your money into something that will grow your money in the long-term.

Given how notoriously difficult it is to successfully pick stocks (or currencies), if you’re a beginner, you might want to start with long-term investing rather than trading. Investing tends to be less risky as you’re more likely to ride out any market volatility in the long run.

As Warren Buffet once said, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

It is legal, but you need to be wary of risks. Forex prices are constantly moving, and some pairs can be more volatile than others. For example, pairs with high liquidity (which means they’re relatively easy to buy and sell without drastically affecting their price) tend to be more volatile. This is usually the case for any pair involving the USD, as it tends to be in high demand.

Everything from inflation and unemployment to political events and natural disasters can affect the price of currency, so it’s difficult to be absolutely sure when you’re making a bet.

Fraud and market manipulation can also occur. For example, five of the biggest global banks were fined £6.3 billion for trying to manipulate exchange rates back in 2015.

Another reason forex can be risky is the number of scams involved. Watch out for:

Spoofing (also called ghosting). This is when someone manipulates the market by placing a large order that they don’t plan to execute to make it look like there’s a lot of interest.

Front-running. This is when a broker who knows their client is about to place a big order, places an order for their own account ahead of the client’s.

Signal sellers. These are firms or traders who promise to identify, buy or sell signals that suggest it’s a good time to make a trade. They charge a fee for this.

Robot scams. These scams promise to make automated forex trades using a trading program, often called a robot.

Make sure you do your own research on the forex broker you plan to use before you invest.

Can you get rich by trading forex?

While you can make substantial gains by trading forex, you can also lose a lot of money. In fact, it’s widely known that over 90% of forex traders operate at a loss.

It’s easy to make a loss if you’re trading aggressively in an attempt to jump on a particular trend, for instance.

Forex trading can be a fun way to dip your toe into the world of investing, but you should stop if you find yourself making unmanageable losses. Remember to never invest more than you can afford to lose.

When you invest, your capital is at risk.

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