What is Forex Trading and how does it work

Gambling in currency markets

The business of trading in the Forex market is one that many people have embraced, and for good reason. It may seem complex and to many, quite daunting, but once you have mastered the basics and begin to understand what it is all about, it becomes a fascinating and potentially very profitable business. There are many warnings that go along with trading in Forex that must not be missed.  In this article I’m going to share some of those warnings with you so that you know what you are in for.  I don’t ever want you to become a ‘Forex fatality’ and so that you will be very successful and profitable in the years ahead.  This is the goal of all of us who trade Forex and I’m glad you’re along for the ride!

There are several factors that should be considered if you want to do business in Forex.  I recommend that you study these carefully before embarking on a trading spree, as small mistakes can lead to large losses.  Later in the article I’ll show you how quickly money can be lost if you happened to trade recklessly, but first let’s talk a bit more about Forex, what it involves, and how to do business the most effective way.

The purpose of this article is mainly to induce you to the basics of how the Forex market operates.  I will caution you and say that you do not need to know all the details of how the Forex market works in order to make money with it.  If you learn the basics, learn an effective trading system and trade that system with consistency and discipline then you will have all that you need for profit.

Intense focus on a profitable system, while controlling your emotions, can lead to exponential gain on your account.  However, losses can happen extremely quickly with currency trading and so you must take great caution to first become a great trader before risking large amounts of money.

Preparation, Practice and Raw Trading Experience Will Win The Day

I want you to understand that the more time and preparation and practice that you invest into your Forex trading career the greater the potential rewards can be.  I do not want to mislead you in any way and make it seem like this is an easy business.  Forex trading is NOT an easy business.  If you have read online where some trader (or marketer) claims that this can be an easy business if you just purchase his or her course, or invest in his or her robot, chances are you are being lied to.  While there are some robots and systems that are very good, they are few and far between.  Forex is a very challenging business and even when you have a great system and the internal disciplines required, it still does not become an easy business.

I have heard it said that Forex can become a SIMPLE business (with lots of hard work and experience), but it will never become an EASY business.  I’m not convinced of that myself, but do agree with it most of the way.  It can get a lot easier after you get into a rhythm with your system.  But at the same time you will always challenge yourself with larger trade sizes as you grow and this will continuously serve to develop your commitment, determination and courage.

Forex Explained

Forex is a term derived from “Foreign Exchange” and is the process of trading different countries’ currencies.  In other words, this is the trade between one nation’s currency and another.  Let’s say that you have 100 U.S. dollars and you are going on a vacation to Australia.  When you get to Australia, merchants, hotels and individuals you might wish to do business with are not going to readily accept US Dollars as payment for goods and services.

So what are you likely to do when you reach the airport in Sydney or Brisbane or Melbourne?  Chances are, you were going to exchange your 100 U.S. dollars for the equivalent amount of Australian dollars.  This is a simple currency exchange.  You will be charged a fee for the exchange service from most institutions.  But rather easily, you are able to change your 100 U.S. dollars into X number of Australian dollars.  The reason we do not know this number is because that currency exchange rate is always changing.  That is, the value of each currency is always fluctuating.

Why Is The Currency Exchange Rate Between Different Countries’ Currencies Always Changing?

It is a good question and an important lesson to understand about the Forex market.  Fundamentally, each country’s currency has a certain value for buying goods and services.  But in and of itself there is no value until we are able to compare it with the value of another country’s currency.  This is where it gets tricky because each country and the value of its currency are in a continuous flux and the values of each are always changing.

For us as currency traders, this continuous flux represents opportunity and the chance to make money.  The idea is to buy and/or sell and make a profit by doing so.  If you are able to buy one country’s currency and the value of that currency increases then you stand to make a profit on the amount of money that you bought.  If you buy 100 U.S. dollars (vs Australian dollars, just for an example) and the value of US dollars goes up 10% then you would now have $110 U.S. dollars (in this simple example).

We as currency traders are continuously looking to buy or sell a currency pair and profit from the change in price.  If we can guess correctly the direction that a currency value will go then we stand to make a profit from the exchange.  And as traders, we are looking to take some money that we have (capital in our trading account) and use it to buy and sell these currencies in the hopes of increasing our account equity (the amount of money that is in our trading account).

The Internet Has Revolutionized Currency Trading

Nowadays it is incredibly easy to begin trading foreign currencies.  In the past it was very difficult and required working with telephones and newspapers in some cases, fax machines and snail mail in others.  Trading currencies might have even involved telegrams, if you go far enough back in history.  The GBPUSD (Great Britain Pound / United States Dollar) pair gained its nickname the “CABLE” because there was a time when a giant cable—a data and communications line—stretched between the UK and United States (in the Atlantic Ocean) that would relay the prices of the currencies and other information between the two countries.

Most of us who are reading this article will have never known the days of phone and newspaper information and ordering or especially the days of the telegram to notify our brokers of a buy or sell order.  (But if you are one of these traders then please leave me a comment below because I would LOVE to hear a story or two from you!)

We Are Currency Traders of The Modern Computer Age

Most of us reading this article have a lot of experience with computers and have not known any other way of trading currencies.  Nowadays, it is even possible for a teenager, with their parents’ permission, to open up a currency trading account online and begin trading within hours—using real, live money.  It is certainly possible to open a demo account and begin trading within 5 or 10 minutes.  This comes as a direct result of the revolution of the Internet and now we, as currency traders, are able to make or lose fortunes within a few hours or a few days’ time.

Don’t believe me that you could lose a fortune in just a few hours’ time?  Try it with a demo account.  Open a $50,000 trading demo account and find a fast-trading Forex robot.  Set this robot to trade on the 1 minute timeframes and let it run.  If the robot is no good, like most robots are, then chances are you’ll be able to wipe out this $50,000 account within a few hours if you trade with high enough risk settings.

For starters, you will be giving a lot of money to the broker as spreads and/or commissions, and on top of that, the losses can quickly mount.  If each trade has a risk of $5,000 then just 10 bad trades in a row will wipe out the entire account.  This is how easy it is to lose a lot of money in a very short amount of time with currency trading!

Millions In Years (Or Less) Is Possible, Though Not Probable

Regardless, you and I are both attracted to the foreign exchange markets because we know that there is a potential to make a large amount of money in a relatively short amount of time.  If you were to read books written by some of the most successful traders then you will be able to understand how they became multimillionaires in less than 10 years in this exciting business.

That may sound simple, but there are parameters that need to be adhered to, and processes that should be understood before you go ahead and trade for real.   If you are a new trader and you carelessly throw money into a live trading account and begin trading without experience then you will see for yourself how easy it is to lose money.  The statistics say that most successful Forex traders have blown up at least two or three live trading accounts before finding their success.

Am I recommending that you blow up a couple of accounts (if you haven’t done so already) so you can get on the track of a professional Forex trader?  Of course not.  There are better ways to become a professional trader.  I’m sure there are some professional traders that never blew up a currency account but these are few and far between.  But do not feel bad if you have—losses are simply a part of the game and a way of moving forward.  With each loss you should learn something and make a commitment to do better the next trade.

But bear in mind also that not all losses come from bad setups or mistakes.  Currency markets are unpredictable and wily and cannot be traded with 100% accuracy.  Some of your trades, no matter how perfect the setups, will result in losses.  Do not be discouraged by this, but simply continue on—learning and growing all the time.  You will see, with experience, that trading is simply a numbers game.  Some trades will be winners and others will be losers.  Your goal is simply to be profitable, even if half of your trades are not profitable.

Where Do We Begin?

To start with, it is important to understand that Forex involves trading in pairs; this means you buy and sell two specific currencies. There are four major recognized pairs, as follows:

British Pound Sterling and US Dollar (GPB/USD)

Euro and US Dollar (EUR/USD)

US Dollar and Japanese Yen (USD/JPY)

US Dollar and Swiss Franc (USD/CHF)

It becomes evident from looking at the above that the US dollar is a major player in the world financial markets. This should come as no surprise as it is a much-used currency in world terms, and does exert a major influence on the world economy. The Pound Sterling, Yen, Euro and Swiss Franc are the other major world currencies, and each has its merits.

In this article from reuters.com you can learn about the daily transactions in the currency market and just how large of a market it really is.

What Does This Mean For You As A Retail Currency Trader?

These are just some of the bride details of the global currency markets.  You’ll need to know that the value of the US dollar plays a large impact on the value of many other currency pairs.  You will notice this in your trading on a day-to-day basis.

Something important that you might want to take from this research, however, is the fact that your trades make up such a very small percentage of the overall transactions that occur each day.  We oftentimes can become self-conscious over our own little trades.  This can mess with our minds and make us wonder whether someone is watching our trades and then manipulating the prices in order to cause us losses.  While there are a few unscrupulous brokers can manipulate chart prices, the vast majority of the time this is not the case.

Our little trades have no bearing on the movement of the currency market.  Maybe if you’re putting up two billion dollars on a trade then this might help move the markets, but we as retail traders are small and our actions have no consequence on the overall market as a whole.  The institutional traders and the central banks are the ones that primarily move the prices of currencies.

Action Step: Find a Broker and Trade

The financial world is a complex one to outsiders, but the most complicated features of trading Forex are handled by the many brokerage companies that are established in the marketplace.  We as traders are only responsible for making the decisions of whether to buy or to sell.  Your broker is going to handle all of the rest of the details for you.  Getting into Forex trading is deceptively simple.  If it was more difficult than perhaps people would take more time to educate themselves before they started trading.  But as it is, it is very easy to open a brokerage account and begin trading foreign currencies.

NOTE: You might find it useful to go to ForexPeaceArmy.com if you are in need of finding a good broker.  They have frank reviews from real users that you can read and benefit from.  You don’t want to go recklessly into a broker relationship without first doing your homework and due-diligence.  Use ForexPeaceArmy.com to help you with your broker selection.  There are other sites available also that can help you with reviewing different currency trading brokers.

What Is A Broker?

These are businesses that buy and sell the currencies for you on request, and they operate only on your strict instructions. It is important to remember that they make their money by taking a small commission (the Spread) off every trade you make, and this amount will be agreed between the two of you as set forth in their terms of agreements.

Funding your account is simple – these days you can do it with a bank account or even a debit or credit card.  Depending on the broker, you can use any currency you wish in your account as the base currency, but this is usually not something you need to worry about.  Many brokerages will offer you the option of letting your account trade with Euros, Pounds or US Dollars.

How Is Money Made In Forex?

So, just how do you make money in Forex? This is the most important question of all, isn’t it?  And it is one that needs careful explanation. Without complicating the issue with too much detail, we will try and explain the process in simple terms.

The trick to making money is to know when to buy, and when to sell.  You can set your buying and selling points in advance of your trade, and the broker will act on your instructions. Here is a simple example: you are trading GBP against USD; you buy when the pound is worth $1.9772, and sell when it reaches $2.0223. You have instantly made a profit. This is, of course, a much simplified example, but it does give you the basic idea of what trading in Forex is all about. The most difficult part in making money is in getting the timing right, and that’s why you need to understand the processes involved in predicting the way currencies will move.

SIDE NOTE: Currencies change value against other currencies all the time, in real time, and thanks to a number of different factors. You will undoubtedly have heard about the ‘weak’ dollar.  This is a way of describing when a currency has lost value.  Reading economic news releases on sites like ForexFactory.com can help you learn how economic world news affects currency price movements.  I highly recommend that you set up an alert at this site to help alert you of important (high-impact) news releases.

Market analysis and prediction

The financial markets are influenced by many different factors and international trade is high among them. Governments and other institutions issue reports on such things all the time, and these announcement will move the prices of different currency pairs.  The essential step is in getting the predictions right, and therefore, making a profit from picking the right market direction. Dealing in Forex is not something that should be done on a whim; it is a serious business that needs to be studied and learned, but it can be done and you can become a professional Forex trader.

Part of the skill is in knowing how to treat the news on the world economy. Let’s say you are trading in USD; a report is issued that states the economic situation in the USA has showed improvement over the previous month. This will lead to traders buying the dollar and, as a result, the dollar will rise in value. Hence, we can see that any positive news regarding the economy of a country marks the right time to buy that currency.  But yet even sometimes when the news is positive it does not always mean that the pair will rise in value.  Always use caution when trading news.  Using news is known as Fundamental Analysis, and some traders draw on economic and political news in equal amounts.

SPECIAL NOTE ON TRADING THE NEWS: News trading can be one of the most profitable sides of the Forex trading world.  It can also, at the same time, be one of the most dangerous.  It is possible to lose hundreds of pips and even hundreds of thousands of dollars trading a news event incorrectly.  But at the same time, is also possible to make the same amount by doing things correctly.  By trading a news event it means that you are waiting for a high impact news event to take place and then either placing a trade in the direction that you think the market will go in or otherwise hedging (opening two opposite positions) to try and capitalize on a price break out.  These can be very effective tools and strategies for earning money with Forex trading but they must be executed correctly in order to remain profitable and not lose your shirt.

If you are looking for more information on news trading then you might want to visit this youtube video I found in the past. It is not a hype or sales video but rather a simple and conservative approach that can be used on major news announcements.  Take a watch through the video and see if this might represent a strategy that you can add to your business for more profits.

Using Technical Analysis

Technical Analysis is the other way of following changes in world currencies, and involves more insight into the way global news can affect the currency prices.  This method is a skill and also an art form that is vital to learn, and it uses charts and figures drawn up by financial institutions to determine trends in currency fluctuation. Once mastered, it can be a very useful and potentially profitable method of trading Forex.  Technical analysis is also the way that most currency traders prefer.  They use charts and the indicators that go on charts to help analyze past price movement in order to anticipate future price movements.

Let’s Wrap It Up

Doing business in Forex can be an exciting and rewarding business, but it pays to learn the ropes in advance.  Again, if you try trading your life savings without mastering the basics and without learning to trade it proven system than you can find yourself in hot water very quickly.  Sometimes the markets do not do as expected – many factors can influence how they behave – so it is equally easy to lose money.  Often, it is much easier to lose money when trading Forex than it is to make money.  There are so many psychological factors that enter into the equation.  By taking calculated risks and by understanding how to do so, you can make money trading the foreign currency markets.

I want to challenge you to study the trading markets every single day.  I believe you should treat your Forex trading career just as a doctor would treat his career.  A good doctor is going to continue to learn about the modern advances in medicine and about any other discoveries that are announced in his area of medicine.  In a similar way you should approach your trading career.  If you approach it with a professionalism of a highly paid medical doctor, this can help you to become a highly paid professional Forex trader.  Since I believe this is your goal, shouldn’t you adopt this ongoing education as your approach?

Please let me know what your thoughts are… if you are having any particular struggles with your trading business then please let me know below.  As you may have already discovered there are about a thousand ways to go about this business and hundreds of different ways of turning a profit.  It is easier to lose in this business than it is to win, but I want to see you win and succeed over the long term.  Please share your questions and concerns here at this point and let me know what you are thinking…

About the author

Rimantas Petrauskas

First I am a father, a husband and then the author of the book “How to Start Your Own Forex Signals Service”. I am also a Forex trader, a programmer, an entrepreneur, and the founder of ea-coder.com Forex blog. I have created two of the most popular trade copiers and other trading tools for MT4 that are already used world wide by hundreds of currency traders.


Leave a comment
  • Once again Rimantas, a very comprehensive article. You really have a passion for FX don’t you.
    No work and a happy new year to you.

    • Dear Conway,

      you are completely right. I do have a passion for Forex and I just love writing. Working on my book right now and doing my best to release an eBook version in January 2014 😉

      You too have a Happy New Year!

      Thank You
      Rimantas Petrauskas

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Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.
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