What is Forex Trading and How Does It Work?

How does currency trading work? Many of us have travelled to another country and exchanged money for their local currency. If this is something you've done, then you have already taken part in a form of currency trading! But some people trade currencies for different reasons other than travel. These people do it to make a profit and they do this by trading forex. Now, you may have wondered "what is forex trading and how does it work?". Well, we're about find out as we explain forex and define the CFD trading meaning in order to understand what CFD forex trading is, and, of course, we'll solidify your understanding by using a real forex trading example. Let’s dive into it!

What is Forex?

1) The meaning of Forex

The first part to answering 'what is forex trading and how does it work' is by establishing what forex actually is. The meaning of forex is simple, it’s short for foreign exchange. It is the process of exchanging one currency for another. The forex market is the largest and most liquid financial market in the world with trillions of dollars being traded every single day.

Let's use a very simple forex trading example and say that you think the euro will go up in value relative to the US dollar. In that case, you'd buy euros for dollars, then later sell those euros for more dollars than what you originally paid, hence, making a profit. At a basic level, that's how currency trading works but there are more factors that come into play.

Forex is greatly influenced by external factors, such as global news, politics, economics and even natural disasters. All of these factors can drastically change the value of currencies, making some currencies stronger and others weaker. Forex trading can create immense opportunities for traders, but understanding how the market fluctuates is crucial when making the right trading move. Only by doing the right research and understanding the market movements well enough can you create great trading opportunities. 

What is Forex Trading and How does it work: Currency Trading

Now that we’ve covered the basics, let’s dive deeper to unwrap what forex trading is and how it works when applied to different types of currency pairs. Let’s look at some key topics:

Currencies are always traded in forex pairs, meaning that you are buying one currency and selling another currency. Each pair consists of:

• A base currency (the first currency listed)
• A quote currency (the second currency listed)

In the case of EUR/USD as our forex trading example, the euro is called the base currency and the US dollar is called the quote currency. If the EUR/USD is trading at 1.1000, it means that one Euro is worth $1.10 USD. If you think that the Euro will increase in value over the Dollar, you'd want to buy EUR/USD, or if you think the Euro will decrease in value over the Dollar, you'd want to sell it.

Let's look closely at a forex trading example:

Suppose you buy EUR/USD at 1.1000. This quote means that 1 euro is worth 1.1000 US dollars. A few days later, the price moves up to 1.1500. That means the euro has strengthened against the dollar. If you close (sell) your position at that moment, you will make a profit. 

Let’s break it down:

You buy 1 Lot (100,000 units of base currency) EUR/USD at 1.1000

1.1000 × 100,000 = 110,000 USD

The euro then appreciates against dollar and the price rises to 1.1500

You cover (sell) the position at 1.1500

1.1500 x 100,000 = 115,000 USD

The profit of this trade is 115,000 – 110,000 = 5,000 USD

(This example is purely for illustration purpose without considering spreads, commission and other trading costs.)

If you’ve made it this far into the course, then you’ve covered the main foundation of Forex trading! But always be weary of the fact that where there is potential for great profits also brings a risk of losses, so it’s crucial to educate yourself on the forex market before making any financial decisions. Now, let’s look into the types of currency pairs.

What is Forex Trading and how does it work: Major, Minor and Exotic Currency Pairs

There are different types of currency pairs: major pairs, minor pairs and exotic pairs, here are some examples of each: 

• Major pairs: EUR/USD, USD/JPY, GBP/USD
• Minor pairs: EUR/GBP, GBP/JPY
• Exotic pairs: USD/TRY, USD/ZAR

Choosing the right type of currency pair is one of the most important decisions a forex trader can make. Each pair comes with its own risks, volatility and trading behavior, so let’s break it down:

1) Major Pairs

Major Pairs in forex are the seven most highly liquid currencies traded against the US Dollar. They are the most widely traded currency pairs and make up the majority of the trade volume in the forex market.

The Major Pairs are: 

Currency Pair	Currencies	Nickname
EUR/USD	Euro / US Dollar	Fiber
GBP/USD	British Pound / US Dollar	Cable
AUD/USD	Australian Dollar / US Dollar	Aussie
NZD/USD	New Zealand Dollar / US Dollar	Kiwi
USD/CAD	US Dollar / Canadian Dollar	Loonie
USD/CHF	US Dollar / Swiss Franc	Swissie
USDJPY	US Dollar / Japanese Yen	Gopher

Why are they called ‘Majors’? Majors are the most traded currency pairs in the world and they include:

• High liquidity (easy to buy/sell)
• Tighter spreads (cheaper to trade)
• Lower slippage
• Plenty of news and analysis available

If you’re looking for a more reliable, stable currency pair, then you might want to consider trading majors!

2) Minor Pairs

Minor Pairs in forex are the seven most actively traded currency pairs that usually don’t include the US Dollar. They include the currencies mentioned in the major pairs above, excluding the USD, traded against each other. Currency pairs involving the JPY are the most dominant forces in minor pairs. However, there are some exceptions including some USD nominated pairs, such as USD/SEK (US Dollar against Swedish Krona) and USD/DKK (US Dollar against Danish Krone) which are classified as minors. Although minors are not traded as widely as the majors, they are still forex pairs with high liquidity.  
 
Some examples are:

Currency Pair	Currencies
EUR/GBP	Euro / US Dollar
AUD/NZD	Australian Dollar / New Zealand Dollar
EUR/JPY	Euro / Japanese Yen

Minor pairs are better for traders with some experience, as they can be slightly more volatile than majors. So if you’re an intermediate to experienced trader looking to branch out of USD-related trades, you might consider opting for minors. 

3) Exotic Pairs

Exotic pairs are currencies from emerging economies, such as the Mexican Peso and Thai Baht, traded against currencies from advanced economies, such as USD and EUR. The liquidity of exotic pairs is much lower than that of majors and minors, which makes exotic pairs less attractive to forex traders.

Some examples of exotic pairs are:

Currency Pair	Currencies
USD/MXN	US Dollar / Mexican Peso
EUR/PLN	Euro / Polish Zloty
GBP/ZAR	British Pound / South African Rand

Exotic pairs are volatile, but with the right experience they can lead to higher potential profits. So if you’re an experienced, high risk trader, you might be interested in trading exotic pairs. Now that we’ve looked at the meaning of forex, how currency trading works and some forex trading examples, let’s introduce another layer: CFD trading. 

What is Forex Trading and How does it work: CFD Trading meaning

When someone is just starting out, it really helps to get a strong grasp on the CFD trading meaning . A CFD (or Contract for Difference) is an arrangement you make with your broker. You aren’t purchasing the underlying asset itself, whether it’s a currency pair, a share or anything else. Instead, you’re making a call on how its price might shift. By trading forex through a CFD, you’re entering a deal based on how a particular currency pair will move over time. You and the broker agree to settle the difference between the price when you open the position and the price when you close it. Your gain or loss comes from that difference. The CFD trading meaning highlights that ownership isn’t required. Only price movements matter. At its core, that is the CFD trading meaning. 

You can go: 

• Long (buy) if you believe that the price will rise.
• Short (sell) if you believe that the price will decrease.

Let’s take the same forex trading example we used above to help you fully understand the CFD trading meaning. If you believe that the EUR/USD will rise, you can place a buy order (“going long”). So if the price of EUR/USD goes up, with CFD trading, you earn the difference between your entry point and your closing price. If the price goes down, you lose the difference.

On the other hand, if you believe that the EUR/USD will drop in price, you can place a sell order (“going short”). If the price drops, you would make a profit. But if the price rises, you would take a loss.

Let’s run the numbers. For most major currency pairs, a single pip refers to the fourth decimal place or 0.0001. 

If you open a CFD position on EUR/USD at 1.1000 and some time later, you decide to close that position at 1.1200. The move from 1.1000 to 1.1200 represents a shift of 0.0200. When you divide 0.0200 by one pip (0.0001), you end up with a total of 200 pips. 

Now, how does that movement turn into actual profit or loss? In forex trading, a standard lot equals 100,000 units of the base currency. Since EUR/USD quotes in USD, one pip on a standard lot is calculated as:

100,000 × 0.0001 = $10 per pip.

So, if we apply that to our example, a 200-pip move would amount to:

200 pips × $10 = $2,000 in profit (assuming no spreads, commission or other costs).

Now if the price moved the opposite direction, that would be a $2,000 loss instead.

That is the CFD trading meaning. If you’re new to trading, you may have also wondered what a ‘pip’ is. But don’t worry, we will cover all of the important terminology in these EC Academy courses.

What is Forex trading and how does it work: CFD Forex Explained

If you’re looking for a clear CFD trading definition, it’s a method used to speculate on price changes within the market. CFD trading is widely used when trading currencies, but many traders use CFDs for a variety of assets, including:

Forex – e.g. EUR/USD, GBP/JPY
Indices – e.g. S&P 500, NASDAQ
Commodities – e.g. Gold, Crude Oil, Natural Gas
Stocks – e.g. Apple, Tesla
Cryptocurrencies – e.g. Bitcoin, Ethereum

Once you understand the CFD trading meaning, you can implement certain strategies across all markets.

What is Forex trading and How does it work: The Benefits of CFD Trading

1) Leverage

Most traders would agree that one of the most attractive features of CFD trading is leverage. Leverage allows you to open a larger position than the actual given price. Let’s take 1:30 leverage as an example. With 1:30 leverage, you can control a $3000 position with only $100. By controlling a larger position, smaller market movements can result in greater profits. Although leverage can lead to greater profit-making opportunities, it also comes with a risk of greater losses. We will look into leverage in more detail throughout this complete course. Understanding the CFD trading meaning will help you appreciate the risks that come with leverage and fast price movements.

2) Going Long or Short

With mainstream investing, you would usually make a profit by prices going up in value. But CFD trading means you can profit from either rising or dropping markets. If you think the prices will go up, go long (buy), and if you think the prices will go down, go short (sell).

3) No Ownership required

When you trade using CFDs, there’s no need to purchase the actual asset. You’re simply reacting to its price movements. Because of this, CFD trading is quicker and offers more room to adjust your positions as opposed to traditional investing where you must own the asset itself.

4) Access to Multiple Asset Classes

You can trade CFDs on a wide range of markets, all through a single trading platform, including MT4 and MT5. This ensures that you can diversify your portfolio and find trading opportunities within a variety of sectors.

Conclusion: Let’s wrap it up!

If you’ve gotten this far, you should now be able to answer the common beginner question of 'What is Forex Trading and how does it work?'. You should also have a basic idea of the CFD trading meaning. Knowing how to answer "how does currency trading work?" puts you in a very good place when beginning your trading journey.

To recap.

Meaning of Forex:

• The meaning of forex trading (foreign exchange trading) is the process of buying and selling currencies. Forex trading always comes in pairs, like EUR/USD or GBP/JPY, and the goal of trading forex is to profit from the changes in exchange rate. 
• The Forex market is the largest and most liquid financial market in the world. 
• There are three categories of forex pairs: Major, Minor and Exotic pairs.

CFD Trading Meaning:

• You can trade forex by using a Contract for Difference (CFD). This allows you to speculate on price movements without owning the asset. 
• CFD traders can use leverage to control a larger position with less initial capital. 
• Trading CFDs means that you can profit from either rising markets or falling markets. 
• CFDs offer more flexibility, by providing access to global markets.
• Trading CFDs involve more risk, especially if leverage is not managed correctly. 

Key takeaways - What is Forex Trading and How Does It Work?

Thank you for reading ‘What is Forex Trading and How Does It Work’. By now, you should have a good understanding of Forex, but this is just the beginning. There are various strategies that we have yet to look into to get you from a beginner to a confident trader. Understanding how currency trading works and the CFD trading meaning is the first step toward becoming a successful forex trader. Keep on reading as we explore the next topic: ‘How the Forex Market Works’.