Updated: Aug 14
What is forex trading?
How does forex trading work? How to trade forex?
Forex trading, short for the ‘foreign exchange’ trading, is not as complicated as one would think. It’s the action where one can buy or sell currencies - and guess what, you’ve already done it at least once in your life (probably).
Whether it was going on holiday, putting money in your bank (yes your bank trades your money), or buying goods from your local corner shop, you are part of the forex market. Directly or indirectly you are part of the buying and selling of currencies globally.
This makes trading forex an easy task, as you’ve already experienced it! Picking it up should be a piece of cake once you finish the LITA trader programme, in our forex trading academy!
Your key goal when trading is to make money. So how does that actually work? The idea is that you sell a currency at a higher price than you originally bought it for.
The same principle that would apply if you were trading absolutely anything else. It’s not rocket science, I promise.
The thing with currencies that makes them slightly trickier, than let’s say trading bricks, is that they are quoted in pairs.
You can’t buy one currency, without having to sell another first.
When you buy a brick, you swap your hard-earned money for a brick. When you buy a currency you swap your hard-earned money… for money. Confused? Let us see how this works with an example:
The above example is a brilliant demonstration of how money is made trading forex. You’re simply buying at the lower exchange rate of GBPUSD = 1.4 and selling at the higher exchange rate of GBPUSD = 1.5. So when you had 14,000 USD, this allowed you to buy 10,000 GBP, because 14,000 ÷ 1.4 = 10,000.
Then when the exchange rate rose to GBPUSD = 1.5, 14 days later those 10,000 GBP can now buy us 10,000 x 1.5 = 15,000 USD.
Overall what happened? On day 1 you exchanged 14,000 USD and on day 14 you got back 15,000 USD, so you made $1,000 profit in 2 weeks! Not a bad days work for the click of a button, eh?
How to Trade Forex:
In order to learn how to trade forex, we must first understand what forex pair is, and how they work. They're a bit different from your traditional assets.
How to learn trading forex: understanding forex pairs
The first thing to grasp is that currencies have exchange rates when traded. This is known as the “ratio” of one currency against another.
For example, EUR/USD tells us how many dollars we can buy with a single Euro. An easy way to remember this is to read the pairing from left to right. The left-hand-side currency is known as the base currency, and the right-hand-side is known as the counter currency.
Base and Counter Currency
Let’s take a look at an example of Euro against the U.S. dollar to explain this:
On the left side of the “/”, we have our base currency, which is the Euro in this instance. The reason it’s called the “base currency” is because it is the reference point of the exchange rate. On the right side, we have our counter currency (sometimes this is referred to as the quote currency).
The exchange rate is 1.1543 - This is telling us that for every 1 euro we have we can purchase 1.1543 U.S. dollars and vice versa, for every 1.1543 dollars we have we can purchase 1 euro.
How does this work when trading the forex pair?
In practice, we would either “buy” or “sell” the currency pairing, as it’s not physically possible to purchase a currency without selling (trading) another for it. When we do this action what we’re really saying is:
When we buy EUR/USD: We’re buying the Euro whilst simultaneously selling the U.S. dollar
When we sell EUR/USD: We’re selling the Euro whilst simultaneously buying the U.S. dollar
Now, when we buy a currency pair our expectation is that the base currency (Euro in this example) is going to increase in value, and the counter currency (USD) will depreciate. The opposite holds true when we sell. When selling EUR/USD we believe the Euro’s value will drop, whilst the dollar’s value will rise.
Forex traders actually have a special name for this particular action, and it’s known as going “long” when buying, and going “short” when selling. A good way to remember this is to think, you have to look down at a short person, so going short must mean you think the market is going down! And then Long must be the opposite by the process of elimination. A neat trick I used to get to grips with these terms a long time ago...when I wanted to learn how to trade forex, just like you!
What does going “Long” & "Short" mean?
Going long (buying), we expect the base currency to strengthen while the counter currency weakens - all at the same time (relative to each other).
Going short, we expect the base currency to weaken while the counter currency strengthens - all at the same time (relative to each other)
Now in terms of the actual exchange rate number, this is where it becomes really simple and all comes together. When longing we want the exchange rate to go up, and when shorting we want the exchange rate to go down.
Deciding why and when to go long or short is where it gets a little more fun - and we’ll come on to that a bit later.
Right now, if you have no forex positions open - you’re what we would call “flat”. When you close all of your positions, you’re closing flat on your day.
Bid, Ask and Spread
When you’re trading a currency pair, you will see two different prices quoted to you. This is the bid and ask price. The difference between those two prices is known as the spread.
The reason these 2 prices exist is that this is one of the ways the brokerage makes money. For those who don’t know who the broker is, they are the guys you go to, in order to buy and sell these currency pairs.
Fun Fact: Your post office that exchanges currencies (in the UK) are a form of forex broker!
What is “Bid”?
The bid is the price at which you can “short” the currency pair. In other words, the price at which you can sell the base currency, and buy the quote currency.
What is “Ask”?
The ask is the price at which you can “long” the currency pair. In other words, the price at which you can buy the base currency, and sell the quote currency.
What is “Spread”?
The spread is literally the bid minus the ask price, and as mentioned before it’s one of the ways your broker makes money. It’s only a small amount, but imagine this across millions of trades each day, it sure does add up!
Here’s a little diagram to explain it all simply:
You may notice, the price at which you can buy at (ask) is higher than the price at which you can sell at (bid). This mechanism means as soon as you click that buy button you will instantly be in a very small loss. The same holds true when you short.
That small loss is 3 pips, or 0.024% or 2.4 bips - and is one of the ways Forex brokers make money. They are a business after all...
What is a “CFD” (Contract For Difference)?
When you’re trading, it would be pretty impractical for you to physically hold all the currencies you’re buying a selling. This is where the concept of CFD’s originated. Instead of buying the physical currency itself (referred to as the “underlying asset”), you buy a “contract” which mirrors the price of the exchange rate. Essentially a derivative of the actual asset itself.
In simple terms, you’re buying a piece of paper that says I own GBP/USD at this particular price, and that’s an agreement you have with your broker when you click the button on their platform.
This has excellent benefits, as it allows you to instantly buy and sell forex pairs, without having to own a massive safety deposit box to store all your cash!
What is trading on Margin?
"But Marcus, I don't have enough money to buy 30,000 dollars!!! Can I still trade?
Yes, you can by trading on margin and using something called leverage.
One of the key benefits of trading CFDs is the ability for you to trade on margin. This means you can actually trade forex with more money than you put into your forex trading account… I know, a wonderful invention… but be warned, trading on margin can be dangerous unless you know what you’re doing. The easiest way to explain this is by breaking down margin into its components:
The initial margin is what you initially deposit into your trading account at the beginning.
The variable margin is what is used as a “deposit” to keep your current positions open.
The margin requirement is the amount your broker requires in order for you to open a position at a certain size. This is usually expressed as a percentage and is also known as “leverage” when expressed as a ratio.
Taking the example of a 5% margin requirement, this would allow you to trade with up to 20 times the amount you deposit in your trading account.
As a trader, this means you can hugely amplify your returns, but at the same time amplify the losses.
This is why it’s very important you have a trading strategy and a plan before you start going out there and buying forex pairs that your friend James in the pub has recommended. As our friendly neighborhood spiderman’s wise uncle once said -
“With great power, comes great responsibility"
He really knew his stuff that guy.
Let's take a look at what our original trade on GBP/USD would've looked like on 1:20 leverage (5% margin requirement) if we utilised it all:
The result is our 7% gain has been amplified by a factor of 20, meaning over 14 days we made over 140%.
If you recall, that 7% increase was equivalent to + $1,000 profit.
With 1:20 leverage the change of GBPUSD from 1.4 to 1.5 (7% Increase) is equivalent to
+$20,000 PROFIT! (+140% gain on your account)
It should all start to make a little bit more sense now on how money is made when trading forex. The powerful tools of leverage and CFD's combined make trading one of the most profitable vehicles you can choose to drive.
But before we can start making those returns, we need a plan. This will be your forex trading strategy...
What is a Forex Trading Strategy?
A forex trading strategy is a plan you make to build a money-making portfolio. It’s your approach to the market. A good forex trading strategy will answer the following questions, no more and no less:
What are you trading?
Why are you trading it?
When are you going to enter and exit?
How are you going to manage the risk?
The aim of the game is to try and predict which currency will gain strength and increase relative to another currency.
"What" is a good forex trade? And "Why?"
To understand this, we need to look at something called fundamental analysis. This is where we consider a variety of economic variables to determine the supply and demand of a currency. Simply, how much money is there in circulation in the economy.
Each currency is backed by an economic region or country. Therefore, what we want to do is take a deep look into how well that economic region is doing to decide whether we want to buy or sell their currency. A lot of traders use things like a macro currency strength meter to do this for them, as it's not an easy task to do alone.
The first step to answering the questions of "what" we want to buy or sell, is to change the question to:
Will the central authorities (the Central Banks, and Governments) increase or decrease the amount of money in circulation?
This is a much better question and can be answered by analysing the below factors for every country/ economic region. There are 6 key factors to consider:
Balance Sheets & cash flow of the central authorities
Once analysed, this will tell us, in the future, if there will be an increase or decrease in the supply of the currency for a particular region. Then from this, we can answer our original question of "what" we want to buy or sell by understanding the basic principles of supply and demand theory...
What is "Supply and Demand" Theory for Forex?
I think the best way to explain this is with a little example:
Once upon a time, in a small town, there was a Gold mine. The miners were working for 2 weeks and found an almost infinite amount of gold, and it was easily accessible to the whole town. In this town, there was a massive "supply" of gold.
As the gold was so easily available, the "demand" for gold was quite low. This made it cheap.
After a month, there was a storm, and it flooded the mines, washing away all the gold that the village had, leaving a small stockpile that was in the Mayor's house. Gold has now become scarce, and the "supply" has become restricted.
As the gold was no longer easily available, the "demand" for gold has drastically increased. This made it a lot more desirable and more expensive.
There are 2 rules we can gain from our story:
1) The higher the supply of an item, the lower its value
2) The lower the supply of an item, the higher its value
This same principle applies to currencies. By using our fundamental analysis, we can determine the supply and demand of the currency, and by net effect, its value.
And just like that, we know "what" we want to buy and sell, and "why" we're doing it... because were predicting the amount of money in circulation using supply and demand theory. The most powerful trading strategy there is and is used by nearly all investment banks (and you soon enough you'll be using it too budding forex trader).
But Marcus, how do we know whether there is more or less money in circulation? The trick is to use a scoring system for each economical variable which makes it easier for us to interpret the data. This is essentially what a macro currency strength meter would do to make it really easy.
Here's an example of how it would work with USD/JPY:
Our macro currency strength meter has already considered if there is more or less money in circulation for the United States and Japan. It then computes the currency score on a scale of -100 to 100 on how strong or weak the currency is dependant on this.
If we have a strong positive score for a currency, we would want to buy it (the currency is in low supply, more demand)
If we have a weak negative score for a currency, we would want to sell it (the currency is in more supply, and less demand)
This would mean, in the above example we would want to "Long"(buy) the currency pair USDJPY!
"When" to enter a Forex trade
Now we know what we're doing, and why we're doing it... "when" do we actually place the trade?
From the above example we want to "long" (buy) USD/JPY, do we do that right now... or next week?
The best traders answer this is with a traffic light system based on the current market sentiment:
If the market is against you - don't enter
If it is neutral - wait longer
If it is supporting you - enter now
The question is, how do we know if the market is with or against us? The way we know this is by reading something called the Commitments of Traders Report, which is released once a week.
This report tells you whether the Hedge Funds are also buying the U.S. dollar, and selling the Japanese Yen.
Very simply, if the hedge funds agree with our idea to buy USD and sell JPY, then we have a green light. If they disagree we don't enter and wait.
We care about what the Hedge Funds are buying and selling as they have the exact same objective as forex traders:
"To make money using our own money"
The difference between a Hedge Fund and your stay-at-home forex trader is that they have a lot more buying power. This means when they place trades, it gives the market "fuel" to push and influence the trade in your favor.
Think of it like this, if the hedge funds disagree with you, don't enter your trade. It doesn't mean your trade idea is wrong, it's just the wrong time. The rocket ship is just fuelling up before liftoff. Your job is to wait till it's ready!
It's one of the most powerful trading tools traders will ever use to make money trading forex.
If you'd like to learn how analyse the COT report so you can use this powerful timing tool, we have a full guide here.
Risk Management - "How" do you manage the risk on your portfolio and trades
Risk management is imperative to make sure you make more money when you're right then when you're wrong. Let's play a little game to transform you into a risk management genius:
Imagine, that these 2 boxes are in front of you right now. The boxes are actually opaque, so you can't see inside them.
Scenario 1 - "Getting Paid"
I want you to pick from either box A or box B. Whichever ball you pick, you get paid the amount that the ball is worth according to the key.
If you pick from Box A and get a blue ball you get paid £1,000, but if you pick the red ball you get paid nothing.
If you choose box B you're guaranteed to pick the green ball and will get paid £700.
Which box do you pick? Write it down, or make a mental note.
Scenario 2 - "Losing out"
Again I want you to pick either box A or box B. In this case though, whatever ball you pick you will lose that amount of money.
For example, if you choose box A and you pick a blue ball you will lose £1,000, however, if you pick the red ball you lose nothing!
If you choose box B, you will pick the green ball and be sure to lose £700.
Which box do you pick now? Write down your answer.
The Risk Management Results
There are no right or wrong answers to the above question, but there are answers that will make you a successful trader.
Scenario 1 - Majority choose box B (certainty of making £700)
Scenario 2 - Majority choose box A (chance to prevent all loss by picking the red ball)
No, I am no wizard, I did not read your mind! This is understanding the innate human instinct which naturally makes use terrible at risk management and trading. You'd be interested to know, successful traders choose the exact opposite of the majority.
Successful traders would pick:
Scenario 1 - Box A
Scenario 2 - Box B
Let's see why:
It's all to do with the maths! Don't worry it's not as hard as it looks.
What a good trader will do is look at both scenario 1 and scenario 2, as an objective mathematical equation, and use probability to make their decision.
Essentially, the optimal solution would be to choose the event, that in the long run, will give you have a higher return given the chance it happens.
With our 2 boxes, A and B, we must first calculate our risk-adjusted expected return for each box... see below on how we actually do this:
In Box A our expected return = £750
This is because there are 3 blue balls, so we have a 75% chance of making £1,000.
In Box B our expected return = £700
This is because there is only 1 green ball, so we have a 100% chance of making £700.
Now in scenario 1, if you recall, this is where we were getting paid. Whichever Box you chose, you got paid the amount of the ball you picked. On a pure probability basis, it is now clear why traders actually pick Box A instead of Box B. With probability and return considered, choosing Box A would lead to you being £50 better off in the long-run, than choosing the guaranteed option Box B (which our natural instincts would tell us to pick).
This is known as taking calculated risk when faced with positive outcomes
In scenario 2, the opposite holds true. The trader wants to minimise the amount of money he loses in the long run. So choosing Box B, where the expected loss would be £700 is the ideal option. Because, if he chose Box A, in the long run, he would be losing an extra £50 - it's that simple.
This is known as capping your downside when faced with negative outcomes
As long as you learn to use the risk-adjusted expected return equation when it comes to managing your trades you will always do the following:
Cap your downside when losing money (pick from box B)
Take on risk when you're faced with making money (pick from box A)
In trading terms, this would translate to having a hard stop loss and soft targets - but that's a bit out of the field of this article... if you'd like to learn that then you should reserve your seat in our up-coming web class that goes through all the above step-by-step and how to actually apply it to the live markets.
Trading Forex UK with Logikfx Academy
Take the first steps into growing your value as a trader with our free online courses, webinars, seminars. All from a small team of highly skilled traders with over 15 years’ experience in the financial markets. Learn how to use powerful tools such as the macro currency strength meter alongside market positioning through a step-by-step COT tutorial - all at your own pace, including interactive exercises, engaging examples, and full support to help you develop your understanding. Trading Forex in the UK hasn't been any simpler than today.