What is Forex Trading and How Does it Works

What is Forex ?

The Forex, short for Foreign Exchange (forex market) is the market where currencies from all over the world are traded against each other in the form of pairs. We call exchange rate the price of exchange between two currencies. Thus, if we take the example of EUR / USD rating at 1.50, it means that with 1 euro, you can get 1.50 dollars. Investors buy and sell currencies in real time and continuously. The exchange rate thus changes constantly based on supply and demand of a particular currency. This has not always been the case.

Before 1944, it was impossible to buy the dollar against the euro. The gold was used as reference in all exchanges (Currencies were only convertible in gold). Then, in 1944 took place the Bretton Woods conference in order to ensure economic stability after war. The key elements that resulted are: Creation of the IMF – Creation of the Central World Bank – Creation of the International Bank for Reconstruction and Development – The dollar has been designated as the single currency convertible into gold while other currencies have seen their rate fixate at + – 1% against the dollar.

Until 1992, the exchange rate remained fixed (or constant relative to a reference currency). The states controlled the price of their currency and made sure she never leaves the exchange rate band that was set (from + – 1% against the dollar at the beginning). The exchange then moved only if a state decides to devalue or revalue its currency by acting with its foreign exchange reserves. Technically, a currency could be attacked on the currency market if the price was too high or too low. That’s what happened in 1992, which was a major turning point for the foreign exchange market.

George Soros, seeing that the price of sterling was too high, decided to shorts it for $ 10 billion. The Bank of England not having enough foreign reserves to maintain its fixed exchange rate was forced to devalue its currency. George Soros has also won more than 1 billion dollar on this operation and was nicknamed ‘the man who broke the Bank of England‘. Other currencies have also been attacked in the following years prompting the authorities to move on floating exchange rates, system that we know today.

The price of a currency on the Forex is now a balance between supply and demand of various stakeholders for a particular currency. Currencies fluctuate 24h/24 and 7d / 7. However, brokers do not allow you to trade the weekend (because of the low volatility), while the market remains wide open for central banks, commercial banks or hedge funds that are key investors on the Forex. Thus, many gaps appear at the opening of the market on Sunday evening.

The Forex market is highly liquid. The daily volume is today of 3.981 billion dollars, making it the second largest market behind the interest rate (8000 billions). There are no worries of counterparty (Especially since your broker is your guaranteed counterparty). The following chart shows the evolution of the daily volume ($ billion) transactions on the forex market:

These 3,981 billion dollars of transaction are composed as follow:

• 1 490 billion spot transactions
• 475 billion forward exchange
• 1 765 billion in swaps
• 475 billion of others transactions

Among these transactions, the most traded parities are the EUR / USD (about 28% of the total volume), the USD / JPY (about 14% of the total volume), the GBP / USD (about 9% of the total volume). The dollar is the most traded currency in the world, it represents more than 85% of trade on Forex, as shown in the graph below which shows the most traded currencies:

So I will now introduce you how the Forex is working…

The Forex, or Foreign exchange market, is i said before the market where currencies are quoted againt other currencies. Example: EURO against the DOLLAR, or more usually known as EUR/USD. So, the value of one euro in dollar is priced.  In our example, the EURO is the basic currency, the DOLLAR is the currency which makes you earn money on Forex or not in your trades. To sum up, whatever you do on EUR/USD parity, sell or buy, you win or lose dollars. When you close your position, the profit or loss is converted into basic currency of your account at the market price.

The parities on the Forex evolve according to the economic indicators of the countries involved in parity. For the EUR/USD it will thus be necessary to take into consideration all the economic news of the Euro area, as well as the United States. Each economic news is forecast, and news better than its forecast generally makes increase the currency concerned. Thus if good news on EURO is announced, EUR/USD parity will goes up and if a bad news comes out, EUR/USD will goes down.

Is it possible to make money on the Forex?

The answer is YES.
YES, if you don’t do anything. Not like “Toto gambles on Forex“. I invite you to consult advices on How to suceed on FOREX in order not to make as the majority of the particular who come to the Forex believing they know everything, being sure to  make money, and finally to get it wrong. (Stage by which I passed of course, otherwise I will not say it)

The Forex is a market that suits perfectly to technical analysis. Indeed, when no news comes out, the market will most likely follow his trend (this is why the Forex is also known as market trend), forming very often beautiful charts patterns. The most found pattern on the Forex is the channel (bullish or bearish), because there is mostly a trend, marked by corrections. In times of economic crisis, of course, the market loses its trend and it becomes more difficult to trade on the Forex.

The Forex is not a really a volatile market. The average daily volatility of parity is about 1.0%. The Forex is made volatile by the leverage. Indeed, if we take the example of an individual investing 10,000 Euros with leverage up to 500, it can trade with 5 000 000 Euros on the Forex. Such a position on the EUR / USD will generate variations on its balance of plus or minus 500 USD per pip. So with a level of EUR / USD at 1.4000, a simple variation of 20 pips in the wrong side will make him lose everything on his account. (Conversely, in 20 pips, it doubles its capital …)

Currencies on Forex