Forex for Dummies Part 1: How Forex Trading Works

Forex trading is a market where buyers and sellers of currencies meet in a platform organized by the brokers. So we have three entities:

1. Buyers
2. Sellers
3. Brokers

Buyers and sellers of currencies are made up of the following groups of people:

1. Individual traders: This is the lone ranger sitting on the computer trying to make a profit from the market on a retail platform.
2. Institutional traders: These are corporations, banks and hedge funds which are manned by trading teams that work as a group to trade the market for profit. They drive most of the trading volume in the market.
3. Central banks: The central banks occasionally intervene on behalf of a currency by buying or selling large amounts of a counter-currency. For instance, if the Bank of Japan wants to weaken the Yen, it will flood the market with large amounts of Yen (i.e. sell lots of Yen) and use this to buy the US Dollar or the Euro or other currency paired with the Yen. This will produce demand for the counter currency, strengthening its value while increasing supply of the Yen, thus reducing its value.
4. Brokers (market makers): Market makers sell to buyers and buy from sellers as part of their liquidity-providing, market making function.

How Money is Made in Forex

Forex trading is a zero-sum game. Any money made is at another trader’s detriment. Any money lost is another trader’s gain. Anytime someone buys a currency, it is purchased from another trader who has sold the currency. Whenever a trader sells a currency, a fulfilment of the order means that a buyer who is willing to deal at that price has been found. The brokers perform the matching process. If the broker is a market maker, then the broker is the trading entity that buys from the seller or sells to the buyer. The reason why it is easy to fulfil orders in a fraction of a second is because at a turnover of 5 trillion dollars a day, the forex market is the most liquid market in the world. Finding buyers or sellers is almost never going to be a problem, unless there is massive slippage.

Knowing that this is the way the market operates will improve the new trader’s understanding of order placement and fulfilment, as well as how money is won or lost in forex.

Forex is traded on a two-way basis. A trader may make money by buying a currency which rises in value subsequently, or by selling a currency which subsequently loses value when compared to another currency. Currencies are traded in pairs. You have to buy or sell a currency against another, because comparison of a currency with another is what produces the basis of exchange rate valuation. Exchange involves two entities; one giving and another taking, or one buying and another selling simultaneously. So when we talk of foreign exchange trading, we are referring to exchange of two currencies at a price, and re-exchange at a different price.

In the second part of this piece, we will look at some elements of forex trading.

Risk warning: Forward Rate Agreements, Options and CFDs (OTC Trading) are leveraged products that carry a substantial risk of loss up to your invested capital and may not be suitable for everyone. Please ensure that you understand fully the risks involved and do not invest money you cannot afford to lose.Our group of companies through its subsidiaries is licensed by the Cyprus Securities & Exchange Commission (Easy Forex Trading Ltd- CySEC, License Number 079/07), which has been passported in the European Union through the MiFID Directive and in Australia by ASIC (Easy Markets Pty Ltd -AFS license No. 246566).