What is Forex? Understanding foreign exchange market

Forex is one of the most popular forms of trading that works both online and offline, but the biggest part of it is done on the internet. Just like other types of trading, Forex is also based on financial speculation about prices.
 
This form of trading uses foreign currencies. And since there are over 200 different countries in the world, the currencies are also around the same quantity. This means that traders can use US dollars, euros, pound sterling, or any other foreign currency to perform this financial exchange.
 
And the question of “what is Forex all about?” can have as simple an answer as this: traders look at the prices of individual currencies and they usually buy them when the prices are low. The market and government policies can have an impact on currency prices and because unexpected things happen all the time, these prices go up and down quite often.
 
And when traders notice that the price reaches their preferred amount, they tend to sell currencies. Because they bought them at a lower price and sold them at higher, they’re getting the payout from this exchange. That’s basically what Forex trading is about.
 
However, one must not think that it’s somehow easy to perform. It’s not - a lack of knowledge and experience can easily cause financial loss. So, traders usually prefer to gain some basic skill set before they start trading Forex or any other asset.

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Trading Forex explained

In trading, there are various assets that people buy and sell to get a payout. These assets range from currencies and shares to commodities and derivatives. In general, people can trade with anything that they own, be it the actual property or a digital one.
 
And in this diverse world, currency trading - also known as Forex trading - is one of the most popular financial activities. And as for the name itself, FX means foreign exchange, which is associated with buying and selling foreign currencies; according to the United Nations, there are 180 official currencies around the world. Therefore, there is a big selection of currencies to choose from.

Real-life example

So, let’s explain how FX works and what its applications are. One of the most popular real-life examples of foreign exchange is traveling. But even those people who do not travel can perform Forex trading.
 
For example, when you want to order a phone online from a different country, you have to follow some steps. If the phone costs $500 and you live in Europe, you need to exchange your euros into the US dollars.
 
Let’s say the exchange rate of EUR/USD is 1.1. This means that if you want to buy $500, you have to sell approximately 455 euros. So, you went to the bank and bought 500 US dollars.
 
But after some time, you decided not to buy the phone. Now, you need to go to the bank and get your euros back. But instead of 455 euros, you’re getting 456, meaning that the exchange rate decreased from 1.1 to 1.09. As a result of these series of exchanges, you gained one euro.
 
So, that’s basically how Forex trading works in real-life. Traders usually put their funds into one particular currency when its price goes down. This way, buying it becomes more affordable. And then, they wait for a suitable moment, when the price goes up again. Then they tend to sell their assets and get some payouts.


Online Forex trading dominates the field

Now, as we mentioned earlier when we were explaining the Forex meaning, this method can work both online and offline. In terms of offline foreign exchange, traders can go to the banks and exchange booths to get other country’s currency. But usually, this type of exchange is done on the internet.
  
And the reason for that is the simplicity and convenience of exchanging funds without having to go anywhere. Online traders can stay at home or be wherever they want and still do Forex with just their laptop and internet connection. They usually find trusted exchange websites, speculate on the increase and decrease of the prices, and then buy or sell the currencies online.














 

Currencies in Forex explained for dummies

As you already know, Forex trading deals with currencies of different countries. And since there are around 200 different currencies, traders aren’t limited to their choices.
 
In Forex, there’s one specific term called currency pairs. It’s basically a connection between the two currencies and their prices. For example, the most popular currency pair is EUR/USD which contains the US dollar and euro.
 

The EUR/USD pair, just like any other pair, has a specific exchange rate. The exchange rate is basically how many US dollars one euro can buy. For example, if the EUR/USD exchange rate is 1.5, one euro can buy 1.5 dollars. In Forex, there are many kinds of exchange rates, including fixed and floating, rising and falling, etc.

 
So, how does Forex work with all of these indicators? Usually, traders wait until the exchange rate on their preferred currency pair, say, USD/JPY decreases; that’s when they tend to buy US dollars. Then, when the price goes up again or even surpasses the previous point, they go ahead and sell those dollars to get even more Japanese yen back.
 

The basic terms and elements of FX explained easily

For beginners, Forex trading can seem quite difficult to understand. However, once they get a hold of basic elements of this activity, everything becomes easier. But that’s not to say the process of trading itself becomes simpler, because it’s not. So, some of the elements of Forex include:
 
  • Leverage;
  • Pips;
  • Spreads;
  • Margin.
 

Leverage

Let’s take a look at each of them. The leverage is basically a multiplication amount of your funds and it’s measured in ratios such as 1:50, 1:100, 1:200 and so on. So, here’s how it works: if you make a deposit of, say, $1,000, leverage can increase your funds by the promised amount. So, if the leverage is 1:50, you’ll get $5,000 on your account.
 
But what does it actually mean? Can you get the leveraged funds right away? Well, no, that’s not how it works. Basically, when you’re getting a certain ratio of leverage, your trading funds increase so that you can buy more currencies online. This, in turn, increases the Forex trading volume and the chance of getting higher payouts as well.

However, there’s also a danger here: on the one hand, leverage increases the possible payout chances; but on the other hand, it also increases the losses. So, if the leverage is 1:50, your actual loss will also be multiplied by 50. In many cases, when someone provides the Forex simple explanation, they try to paint leverage as only a positive feature, however, as you can see in the previous example, it can also be damaging.
 

Understanding Forex pips

Pips are yet another key indicator in Forex trading that represent the change in currency prices. A pip is the smallest price change that can occur in any currency price and is usually equal to 0.0001 price change (in other pairs, it’s equal to 0.01). For example, when the EUR/USD exchange rate increases from 1.4999 to 1.5001, you get a two-pip movement.
 
But, as already mentioned, some pips are counted differently and instead of 0.0001, they represent 0.01 change in price. That’s because some currency pairs like EUR/USD are more stable and require much more detailed indicators like 0.0001-change. But some, such as USD/JPY, can change more quickly like from 103.34 to 103.36. That’s why they need a looser indicator like 0.01-change.
 

Spreads - a difference in pips

Now, spreads and pips are somewhat interconnected: a pip is used as a single unit to count spreads. And here’s how it works: every currency pair has two prices - bidding and asking. A bidding price is basically a buying price at which a trader is ready to buy, say, US dollars for 1 euro. Asking price, on the other hand, is a selling price at which the market offers US dollars for 1 euro.
 
Usually, the buying price is higher than the selling price. So, a trader might be able to buy 1.4999 US dollars with 1 euro; however, that same 1 euro can be sold for, say, 1.4997. Such a difference in buying and selling prices can eventually bring payout to the Forex trader.
 

Margin

What is Forex margin? Margin in Forex trading is closely connected to the leverage. It’s sometimes called a mutual agreement between the trader and the trading establishment whose platform the trader uses. So, here’s how it works: when a Forex trader wants to trade, for instance, $100,000 of the EUR/USD currency pair, they’re not required to deposit the whole $100,000 on their account.
 
With the help of margin, they can put a certain amount of their funds to the trade while the trading establishment covers the rest. So, if the margin rate is 1%, the trader can deposit $1,000 on their account while the partnering establishment will cover the rest of $999,000. A similar thing happens with leverage.
 
But it also comes with its risks: margins have a certain limitation to the losses in trading. If a trader approaches the loss of $1,000 in the same marginal rate of 1%, the establishment might ask them to either increase the deposit or the whole trade closes and the deposits will be lost.

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Technical characteristics of what Forex is

As we’ve come to conclude, Forex trading is all about exchanging currencies of different countries and getting a payout from it. And it has its advantages and disadvantages. Let’s take a look at both.
 

Currencies can be easily bought/sold

Another very important feature that is necessary to understand FX is liquidity. Basically, it’s the ability to quickly buy and sell currencies.
 
And if one particular asset group is more liquid than anything else, it’s definitely currencies. In fact, economists usually measure the liquidity of other assets in currencies because they’re the most easily exchangeable values on the market.

Benefits and risks in Forex uncovered

Leverage is an important feature in Forex. As mentioned earlier, it increases the funds that can be put into trading. Therefore, it also boosts the payout amount. So, if the leverage is 1:100, the payout also increases by x100.
 
But Forex doesn’t come without its disadvantages. Leverage can also act as a disadvantage to it and here’s why: while the 1:100 (or whatever the ratio might be) increases the payout amount, it also increases the possible losses by the same amount. So, greater leverage comes with the risk of a greater loss.
 
In fact, with or without leverage, Forex trading is a risky process and should be done carefully. Many successful traders usually prefer to get some basic knowledge in currencies, government policies that influence them, and then start trading.
 
But even after that, the risk doesn’t go away completely. It’s still possible to lose money in trading because some currencies can be very unstable. So, being careful and always considering the risks can be beneficial to Forex trading.

 

FAQ on what Forex is and how it works

How do I start trading in Forex?
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Forex is one of the most popular forms of financial exchange in the industry. So, you can easily find online material on what FX is and how it’s done.
 
Therefore, the first step in starting your own Forex education, that’s widely used by successful traders, is to get knowledge and skills. Knowing how currency markets work, how inflation and other political factors influence currencies, and how it translates into trading can potentially help in making better decisions.
 
There’s also another method of starting trading right away. Some traders believe that knowledge comes in the process, that’s why they prefer not to lose any time and start Forex trading from the beginning. It depends on the individual, so, trying different methods and working them out yourself is probably a better idea.
How safe is Forex?
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People, who are interested in how FX works, must also realize that it also comes with risks. Because one of the characteristics of FX, as well as other financial markets, is how easy it is to lose funds.
 
And like other types of markets, Forex is also very risky and requires knowledge and skills to make better trading decisions. And even then, the risk of losing funds doesn’t go away. Even FX experts are still vulnerable to currency markets and sudden changes in prices. So, they tend to get as much knowledge in Forex as possible which helps them avoid some bad decisions.

What is a trader in Forex?
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In Forex, probably the most important actor is a Forex trader. They’re the ones who ultimately make the decisions, as well as influence some market forces such as demand.
 
In short, here’s the FX definition of a trader: a Forex trader is a person or an entity who buys currencies, sells them, and eventually, gets a payout. In short, Forex traders take part in price speculations and guess the right time to buy and sell currencies.
Is Forex legal?
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Forex, just like any other type of market, is a financial activity, that’s why it’s regulated by many countries around the world. The governments ensure that traders, as well as other institutions, comply with the highest financial standards that protect customers.
 
And while in the majority of countries, Forex trading is legal, there are some countries that completely ban this activity. For example, Belgium, France, Israel, and some other countries prohibit their citizens from trading Forex.
 

Why is Forex difficult?
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Finance, in general, and not just Forex, is a risky business. As mentioned in the article, many traders, even the experienced ones, do sometimes lose money due to sudden price changes, as well as some bad decisions.
 
But sometimes, the emotional response is also a very important part of Forex. Yet many people wonder why the mindset is correlated with so many difficult aspects of Forex. Here’s what people need to realize when trying to understand FX: when things are going great and you’re getting a payout, it seems like there’s nothing to worry about.
 
However, as you start losing some funds, then you become anxious which brings even more losses. And ultimately, it becomes a circle of increasing losses. To avoid this, traders make a mindset that every trade has a potential loss with it.
 

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