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What is Forex trading?

Alright, let me try and guess what happened with you and how you came upon this article. So you’re just minding your business, scrolling through the internet, and BAM! You get a random ad about Forex trading so you start getting all these questions like, What is this Forex? What do you mean Forex Trading? What is Forex trading? Why are there so many single dads that got rich from it? Can I get a yacht without leaving my house too?

Did I get them right? Admit it there’s something true about that. Nevertheless, these are the questions that most people never before exposed to Forex trading get to ask, but often don’t find the best answers. So put your seatbelt on and let me get in the driver’s seat. Today I will be explaining to you what Forex trading is.

Now, I’m assuming that you already know what Forex is. If not then you’re quite lucky because we’ve already made a post about that topic here on ForexNewsNow. So before you dive here, make sure to give a quick look to the other article. So without further ado, let’s begin.

What is Forex trading and how does it work?

Forex trading is something kind of exclusive to you and me if we decided to trade. To put it into perspective, there are two segments of the Forex market. There are the big boys of Institutional Forex (Institutions, banks, corporations, government etc.) and there are the smaller players like you and me, just individual traders, we are called Retail Forex traders.

We’ll be focusing on Retail Forex trading because that’s pretty much the definition of Forex trading. Now, what is this about trading? what do you trade? Is it like the games we used to play in our childhood? Well, no not really. Forex trading is basically the exchange of one currency for another. Let me bring in an example.

definition of Forex tradingLet’s say Jim decides that he wants to buy something from a French e-commerce store. But he finds out that the store only features Euro transactions, meaning that his account that only has dollars can’t access it, the payment will not go through. Most of the times the transaction providers convert dollars to euros for you, but for the sake of the story let’s say they don’t. So after Jim finds out about this, he decides to go to the bank and get some Euros, he knows that the item he wants to buy costs 50 Euros, so he has to pay $100 to get them. But something comes up and he has to reschedule his visit to the bank for next week. After the week he goes to the bank and buys the Euros, but something weird happens, he doesn’t get 50 Euros, he gets 60, that’s because the price of Euros changed relative to the Dollar. Ok so Jim now has 60 Euros, but after another week of thinking, he decides that he doesn’t want the item anymore, so he goes back to the bank to get his dollars back. But once again something weird happens again. Instead, the bank giving him his $100 back, they give him $90, what happened? Once again, the price of the Euro changed relative to the Dollar. After these 2 weeks of trying to buy an item and holding onto money, Jim lost $10. Inadvertently, Jim conducted a Forex trade, now it may have been accidentally, but it was a trade nonetheless. This is the easiest way I could write what the definition of Forex trading is. Hope you appreciate the creativity.

Forex trading is done completely online

Forex trading explainedNow for you and me, it’s not obligatory to go to a bank or an exchange to make trades. We can just use the internet and do it all day every day. This means that we are speculating. Now, what is speculating? It’s pretty much self-explanatory. Let me bring another example.

I think that the price of the Dollar relative to the Euro will decrease in the next week. Which means that I should now buy Euros, and when the decrease actually happens I am going to sell the Euros, putting me at a profit for the dollars. Now if I am mistaken and the price actually increases, it puts me at a loss, because now if I sell my Euros, I’ll get fewer Dollars than I paid for them.

Forex trading explained in currency pairs

You’ve probably noticed that I’ve only been mentioning Euros and Dollars. Why not only dollars or only Euros? I understand what you mean. it’s trading so what’s the problem? I can trade a bike for a bike, but can’t trade Euro for a Euro? Well, here’s the issue. The bikes can have different values for different people, meaning your bike may cost $500 dollars to you, but for the other person it may cost $600, therefore he’s interested in trading. But in terms of currencies, it has the same price for everybody, $1 is always worth $1. That’s why the definition of Forex trading is in currency pairs.

definition of forex trading

But how many pairs are there? A lot, okay? There are hundreds of currency pairs out there right now, but not all of them are accessible everywhere. Okay, let me bring it more into perspective. Take the US dollar and multiply it by every currency there is, that’s the pair count for the USD, now do it for everyone else, by the time you’re done you get to the thousands, don’t you? Thankfully though, there are mostly Major currency pairs featured online. What’s a major currency? Here’s the list:

  • USD
  • EUR
  • GBP
  • AUD
  • CHF
  • JPY
  • CAD

Now pair these up together and you get a Major currency pair.

Now if you want to trade your Local currency paired with the USD, it’s mostly available with a local Forex broker, all you’ll need to do is ask. However, brokers that focus on international business, very rarely feature a non-major currency pair, so keep that in mind.

What is Forex trading with leverage?

Trading with major currency pairs is a lot more stable than others. Which means that the volatility is not the best. Although it is easier to predict price changes for major currencies, it’s a bit harder to make more money with them. However, the Forex brokers have already looked into this issue and introduced leverage trading. What is Forex trading with leverage you ask? Well, it’s story time again, read closely.

Let’s look into Jim’s childhood, shall we? When Jim was 8 years old, he used to buy an apple on his way to school for $1 at the market. Now he didn’t eat this apple, but sold it to his classmate for a profit (smart kid eh?). So his Father found out about this and told him this “Let’s work on your Entrepreneurship, I’ll give you $10 every morning before you go to school, and you have to give it back to me when you get home” (You see where the genes come from now don’t you?). So Jim accepts the offer, he gets his $10 with his $1 and buys 11 apples. With this, he is able to make a lot more money and is able to pay his dad back. This is essentially how leverage works, the broker allows you to trade with more than you have deposited, for example, if you deposit $100 and the leverage is 1:5, you’ll be trading with $500.

what is forex trading leverage

When explaining what is Forex trading with leverage, I need to say that there are also risks connected to it, let’s go back to Jim. So it’s Friday and Jim is preparing for school again, so as per usual his dad gives him the $10. Jimmy buys his 11 apples and arrives at school, but oh no! It looks like both he and his dad forgot that today is a holiday, so there’s no school. All Jim has left to do is explain to his dad, but he doesn’t want to hear it, he doesn’t want the apples either, now Jim can hold onto these apples until Monday, but by then they may become rotten (I know this is unrealistic, but just bear with me here). Therefore, Jim is now in debt of $10 and doesn’t know how to pay it, he doesn’t have any more credibility for another handout of $10, so he’s in big trouble.

This is one of the risks that traders face when trading with leverage. In addition, if we were talking about real brokers, the dad wouldn’t want $10, he would want $11. Because the leverage is a service, so the broker is entitled to try and make a profit out of their offering. Usually, the bigger the leverage, the more profits you can make, but ultimately it can boil down to more losses and more debt.

What are the costs of trading Forex?

You’ve probably mentioned that we’ve been talking about Forex brokers in the last paragraph. Who are they? Are they the key to explaining Forex trading? Well, they are the people that you and me (Retail Forex traders) go to, in order to actually start trading. These are the people that create platforms for us and allow us to make the trades. But there is one thing you need to consider. Trading on a Forex broker’s platform is a service, and like any other service, it comes at a cost. And there are sometimes shady ones so make sure to research.

what Forex trading costsNow there are several ways that Forex brokers price their services. The most common one is the “spread based commission”. By spread, we don’t mean cheese spread or something like that. A spread is a difference between the asking price and the bid price. What am I talking about? Let’s tell another story (Now starring yours truly). I call it “paying for Forex trading explained”, cool name isn’t it?

I am at college and meet this cool guy named Jim, he’s the same age as me and is a re-seller. Which means that he buys stuff from people and then tries to sell it for a profit. One day I decide that I need to sell my old laptop and buy a new one. So I call Jim, he comes over and I sell him my laptop for $900, but then I get a phone call telling me that the real price of the laptop I just sold has will soon increase in price. So I turn back to Jim and tell him “Hey man, I’m really sorry but I’ll need to buy that Laptop back”. Jim will understand and give it back to me but now, he gives it to me for $950, because he actually came here allowed me to use his services, so he still needs to get paid. All this means is that I lost $50 because I was too quick with my buyback.

The same thing happens with Forex brokers and their spread commissions. Let’s say that a broker’s spread for Euro/Dollar is 0.02, now let’s say that the asking price is 1.24 and the bid price is 1.22, this means that if I buy a Euro and then immediately sell it without waiting for the price to change, I’ll be at a loss because I would have to pay the $0.02 as commission.

Advantages of Forex trading

Since we’ve already discussed all the technical stuff, let’s get to the actual advantages you can find with Forex trading compared to other markets.

Liquidity

what is Forex trading advantage

Trading Forex is a lot faster, why? Because of the liquidity. Liquidity is when something can be sold easily. For example, an apple (I like fruit if you haven’t noticed already) has more liquidity than a house. The reason is that there are considerably more people willing to buy an apple, than a house. Plus its all about affordability. But how can we have liquidity in Forex trading explained simply? Now let’s look at it as a financial standpoint. How many people do you think are willing to buy currency compared to a stock? A lot more, because currencies have a lot more applications, they have more demand. Plus it is way easier to sell a currency when its price is going down compared to a stock. Because imagine, If the price of the dollar is going down, somebody out there will definitely want to buy it so that he can use it in another pair for trading. Now when the price of a stock is going down, there are only speculators out there who hope that it will rise up again and prepare to buy. So you have drastically different potential buyer base. For Forex its a lot larger, meaning that it will be easier to find a buyer.

Leverage

what is Forex trading advantageLeverage could be an advantage as well as it can be a disadvantage. Remember what happened to little Jim? Well, you should also remember when everything was going great for Jim as well. You see there is a limited amount of leverage (or margin) that a stockbroker can give you. While the Forex broker can hook you up with a 1:500, ultimately skyrocketing your profits. But it does come with the disadvantage of potential high losses.

Disadvantages of Forex trading

Now let’s talk about the things that most people are afraid of when thinking about an FX trading definition. But they’re nothing new, pretty much everything that involves making money, also involves losing money, let’s get into it.

The risk

what is Forex trading disadvantageNeedless to say, Forex trading is a lot riskier than stocks. The volatility or the frequency at which prices change is very high. Meaning that there is never a guarantee that you will make a profit. It nearly always 50/50. However, with stocks, it’s a safer investment, but a longer one as well. For example, there are large companies in the world, who never really suffer losses that affect their stock price. Therefore, they always have a steady increase, making them a lot more safe and less volatile, take for example Apple or Samsung. Besides, you can always go with an international company, whose failure in a specific country may not mean much. But in terms of Forex, if a specific country is facing issues than you can be sure that their currency will suffer.

Conclusion

Alright, Let’s wrap it up shall we? Now, what did we learn? We found out that Forex trading comes with its advantages just as well as with disadvantages. It means that it isn’t perfect, that’s when you know it’s realistic. The ads you saw about single dads buying yachts and becoming financially independent aren’t completely false, it’s just really hard to get to that point. Sure you’ll get there if you spend your day taking risks, reading news and spending quite a lot of cash in the beginning.

Ultimately what this article wanted to tell you is that it’s okay to be hesitant. It’s about money so naturally, there are some “What ifs”. All you need to know is that it’s just complicated from the beginning, later it becomes a piece of cake. Just remember the first time you tried riding a bike or swimming.

All in all, I congratulate you with your decision. You are in the top 10% of the people who actually research what FX trading is before they dive right in. Keep that attitude up and who knows, maybe you’ll invite me for a yacht ride some day.

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