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How does Forex work

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Forex traders have a hard time understanding how forex trading works or if currency trading really works.

This article explains in detail the Forex Market, commonly known as the FOREX

Forex (Foreign Exchange) is the foreign exchange market, where currency pairs, such as EURUSD or GBPUSD, are traded. Forex is an over-the-counter (OTC) market where investors or speculators will buy and sell currency pairs.

Forex is the currency market and currencies, unlike most other tradable assets, are economic instruments as much as they are economic indicators. Basically, if the countries were companies – the currencies would be their shares.

The Basic Terms of Forex Trading

The language knowledge of Forex brokers will not make you an excellent trader, but it will help you understand the data needed to turn into one.

Here are the most important terms of Forex Trading:

  • Currency Pairs
  • Forex Trading
  • Pips
  • Spread
  • Margin
  • Forex leverage
  • Swap
  • The Lot or the size of the contract
  • CFDs
  • Forex platforms

Any investor who wants to engage in currency trading needs to understand how forex works and the basic terms of that market. Testing forex trading on a demo account is one way to learn and better understand forex.

Forex Quotes – Explanation

The currency pair is a key notion for the fundamentals of Forex trading. For example, the EUR / USD pair. The euro is called the base currency. The US dollar is called the counterparty currency. The valuation of the base currency against the counterparty gives us the Forex quotation.

If you look at the EURUSD or other currency pairs on the trading terminal, you will see two digits, the ask price and the bid price. They look like this: EUR / USD 1.1234 / 1.1240. This quotation tells us that we can buy a euro with 1.1240 US dollars because it is the amount requested by the bank – the asking price.

At the same time, we can sell one euro for 1.1234 US dollars – the bid price. It is easy to note that, in general, a bank buys a currency for a lower price and sells a currency with a marginally higher cost. Banks can do this because they have more influence than brokers.

You cannot just buy or sell EUR / USD, as you would for example with the shares of a company. This is because the EUR / USD currency pair does not exist. The currency exists alone, not in a couple. Traders simply speculate on future price movements, without actually buying currencies.

On the Forex, the profit is realized by the appreciation or the depreciation of the value of a certain currency compared to the other. Let’s say you buy euros and sell US dollars (using the EUR / USD currency pair). To make a profit, you have to sell the US dollars once the euro has appreciated against the dollar.

There are two things to consider. First, traders never buy or sell physical currency. Second, the buying and selling takes place in all foreign exchange transactions.

What are the currencies traded on Forex?

This guide on how the forex works would be incomplete without the review of the most popular assets available to a trader.

The most popular currency pairs in the world – the US dollar, the euro, the pound sterling, the Japanese yen and the Swiss franc are part of a group of major currency pairs: EURUSD, GBPUSD, USDJPY and USDCHF.

There are three other currencies that are common in Forex trading: the New Zealand dollar, the Canadian dollar and the Australian dollar. If they are associated with the US dollar, we get a group of minor currencies: NZDUSD, USDCAD and AUDUSD.

All other currency pairs in Forex trading are generally referred to as “exotic currency pairs” and account for less than 10% of all foreign exchange transactions.

Who trades Forex?

The most important players in the forex market are:

  • Central Banks
  • The states
  • Other banks
  • Hedge Funds
  • Investment Funds
  • Brokers
  • Professional and Individual Investors

Among the participants in the currency market, the central banks have the most weight on the formation of currency prices. 

A central bank is in fact the money provider for the country where it operates and is therefore the supply in this market. These decisions have a very important impact on the price of currency pairs.

Small investors, like individual traders, have a very slight influence on the market, but this influence is evident because of their large numbers.

To understand the forex, we must know that the supply and demand of currencies is constantly changing and we can see the movement of prices on a tick chart on the trading platform for example.

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