What is Forex Trading and How Does It Work?

How does currency trading work? This is something you may have heard thrown around in conversation but have never fully grasped. You probably know that when people travel abroad, they must exchange their own currency for the local one in order to spend money in that country. However, many people also trade currencies purely for profit by participating in forex trading. If you have heard about this type of trading before, then you may have wondered "what is forex trading and how does it work?" This article will answer that question and also explore some forex trading examples. Forex is often traded via Contracts for Difference (CFD), so we'll dive into the CFD trading meaning and how CFD forex trading works.

What is Forex?

To answer the big question, "What is Forex Trading and How does it work?", we must first make sure you know that Forex (short for Foreign Exchange) is the process of exchanging one currency for another.

When doing so, there is always a foreign exchange rate that determines how much of one currency you will receive in return for another. Over time, an exchange rate can move up or down, which can affect the cost of swapping currencies.

Foreign exchange rates are greatly influenced by external factors, such as global headlines, politics, economics and even natural disasters. All of these factors can drastically change the value of currencies, making some currencies stronger and others weaker. A trader who does the right research and understands how the forex market fluctuates can identify and capitalise on immense opportunities.

How does Currency Trading work?

In forex, currencies are always traded in pairs. These are called 'Currency Pairs' or 'Forex Pairs'. Currency Pairs always involve one currency being sold while the other is being bought, and the exchange rate indicates how much of one currency is required to buy the other.

Each currency pair consists of a 'Base Currency' and a 'Quote Currency'. The base currency is the first currency listed and it is the currency being bought. The quote currency is second currency listed and it is the currency used to show how much is needed to buy one unit of base currency.

An easy forex trading example is the EUR/USD pair. In this case, the euro is the base currency and the US dollar is the quote currency. If the EUR/USD is trading at 1.1000, that means one euro is worth 1.10 US dollars. Now, a forex trader may predict that the EUR will rise in value over the USD, in which case they'd buy EUR/USD. Conversely, if they predict that the EUR will fall in relation to the USD, then they would sell it.

A Forex Trading Example: EUR/USD | What is Forex Trading and How does it work?

Let's continue with our forex trading example, the EUR/USD, and use a realistic trading scenario to further answer "How does Currency Trading work?"

Suppose you bought EUR/USD at 1.1000 (i.e. you bought 1 EUR for 1.10 USD) and a few days later, the price increased to 1.1500. That means the euro has strengthened against the dollar. If you close (sell) your position at that price, you will make a profit. 

Let’s break this down further:

1. You open (buy) a position at one 'lot', which is 100,000 units of base currency, EUR/USD at 1.1000.
   
   1.1000 × 100,000 = 110,000 USD
   
   
2. The euro appreciates against dollar and the price rises to 1.1500. You cover (sell) the position.
   
   1.1500 x 100,000 = 115,000 USD
   
   
3. The profit of this trade is 115,000 – 110,000 = 5,000 USD

(This is an extremely simple example and is purely for explanatory purposes. It does not take into account spreads, commission and other trading costs.)

So far we've covered the main foundations of forex trading! You should be able to give a basic to answer to 'what is forex?' and 'how does currency trading work?', as well as have a good idea of a forex trading example. It’s crucial to educate yourself on the forex market before making any financial decisions because although there is potential for great profits, there is a risk of losses.

Now, what are currency pairs?

Types of Currency Pairs | What is Forex Trading and How does it work?

Part of having a good understanding and answering 'how does currency trading work?' means being aware of the different types of currency pairs, including 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 behaviour, so let’s break it down:

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: 

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:

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. 

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:

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.

There is more to answering 'how does currency trading work?'. Currency pairs are often traded as forex CFDs. CFD forex trading is a fast-moving, leveraged market. Let’s introduce another layer and uncover the CFD trading meaning. 

CFD Trading Meaning | What is Forex Trading and How does it work?

When getting into forex trading, it's important to know 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. 

With CFD trading, 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 use a CFD forex trading example 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 forex 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 on this same CFD forex trading example, the EUR/USD currency pair. For most major currency pairs, a single pip refers to the fourth decimal place or 0.0001. If you open a CFD forex trading 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 CFD 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.

All in all, the CFD trading meaning can be defined as a method used to speculate on price changes within the market. CFD forex trading is done widely in the world of CFD trading, but many traders also 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 start to learn about different trading strategies that you can implement across various markets.

The Benefits of CFD Trading

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.

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).

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.

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 | What is Forex Trading and How does it work?

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

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’.