What is Forex Trading & How does it work?

Trading in the forex market is very popular globally & also in Nigeria. According to estimates that there may be as high as over 200,000 forex traders in Nigeria currently.

Forex trading, also known as foreign exchange trading or currency trading, works on the principle of making a profit from the fluctuation in price movements of the two currencies in a currency pair.

Forex trading involves understanding the basics of the trading, certain instruments involved and how the market works. We will explain them all in this tutorial.

What is Forex Trading?

Forex trading involves trading different currencies in the global foreign exchange market against one another. Forex Trading is done in Foreign Exchange Market via a forex broker.

Foreign Exchange Market is one of the most actively traded markets in the world. The FX market has an average daily trading volume of close to $6.5 trillion as per the recent reports by BIS.

The buyer or seller speculate on their bias on the currency’s movement in the future and get into a forex trade. This market has a high risk involved and is directly traded between two parties, OTC (over the counter) market. There is no central location of this market. Forex trade can be done 24 hours a day.

Let’s take an example: of USD (US Dollars)/NGN (Nigerian Naira). If you want to buy US Dollar by exchanging it with Naira, for this you need to spend NGN equal to the FX rate of USD/NGN. In this case, you would buy US Dollar if you are expecting USD to get stronger in future against Naira.

Forex Trading Terms

There are a few basic terminologies that you will come across once you are actively trading in the forex market.

#1 Base & Quote in a currency pair: Every currency pair has a base currency vs a quote currency. Base currency is the buying currency when you trade the forex trade. Quote currency is the selling currency when you trade a forex pair. For example, GBP/USD. Here GBP is the base currency and USD is the quote currency.

Base & Quote in Currency Pair

#2 Bid & Ask prices – Trades for any currency pair takes place at Bid & Ask (or Order) prices. These are quoted by the brokers or Market Makers who facilitate such trading. Bid price is referred to as the price at which the buyer would want to buy the foreign exchange and the Ask price, the price at which the seller is offering the foreign exchange.

The Bid/Ask prices are always quoted in pairs for trading. For example, if the pair of USDCAD is trading at 1.4084/1.4284, that means you can sell 1 USD for 1.4084 CAD and you can buy 1 USD at a cost of 1.4284 CAD.

#3 Currency Pairs (Majors, minors and exotics) – Trading in the forex market always involves 2 currencies together & against each other. Like 1 EUR against US Dollar.

The currency pairs in which the foreign exchange is done are divided into three major categories.

  1. Majors are the currency pairs that have the highest trading activity. There are 7 majors.
  2. Minors are generally the currency pairs that are crosses of pairs in Majors except US Dollar.
  3. Exotic are currency pairs of emerging economies & other countries. These generally have low trading volume, so can be very volatile.

How does the forex market work?

The demand and supply is what makes the forex exchange market move. Demand for one particular currency against the other is what decides the exchange rate of the currency pair and hence move the market.

The fluctuation in the demand and supply of these currencies affects the exchange rate. Eg: If there is an increase in demand for US Dollar due to global fundamental shift, then it will rise against most other currencies that have weaker demand than US Dollar.

So, what effects or creates the supply & demand?

The Forex Market has several factors which influences the supply & demand for a currency. Let’s see some major factors which come to play in a forex market:

There are 3 major factors that affect the currencies fundamentally:
#1 Economic Outlook & Conditions: The economic conditions is the most important factor. In case of present times, where we are facing the global Covid -19 pandemic, strong economies like USA, considered as one of the most powerful economies, has also been affected by this pandemic. Any changes in the economic activity of the countries affect their trading abilities and hence, affecting their currency rates.

This has made the once stronger currency, like USD, weaken to some extent in the current situation due to weak economic outlook in the US. The currency pairs with USD can be now bought and sold in the forex market cheaper than before. Economic conditions in a country have a major impact on the exchange rate of their currency.

#2 Central Banks: Central banks play pivotal role in the currency’s outlook, because they act as the gatekeepers, policymakers related to country’s economy.

Any policy change or negative/positive outlook on the economy by Central Bank’s policies would impact the currency of the country. Eg: During end of capping on CHF (Swiss Franc) by Swiss National Bank, caused major movements & veru high valatility on CHF pairs in 2015, that even led to some brokers filing for bankruptcy.

USDCHF chart showing market impact by economic news

#3 Economic News: The economic news affects the foreign exchange market in various ways. The inventors speculate the rise or fall of a currency vs the currency pair. As speculation comes in the picture, the speculation is solely done on the economic news that is seen and read on daily basis. The economic news is followed and studies. Decisions are made basis rise or fall in the world economy on daily basis.

#4 Market Sentiment: Market sentiments, like above factors, also are related to the perception of the market makers and other parties involved in the trading. There may not be any positive or negative news, but based on what the market participants feel about the economic and market conditions, the currencies can get affected. Hence, market sentiments too should be kept in mind while taking any trading decisions.

Why Forex Trading is Risky?

Forex Trading involves huge risks, just like any other investing instrument. It is important that you learn about these risks.

Let’s see the 5 major risks that should be kept in mind before trading:

#1 High Leverage Risk: Most brokers offer margin trading, with which you can trade with more money than the actual capital that you have invested.

Let’s say that your broker offers 1:10 leverage. Using this as an example, with just $100 of your own capital, you can trade as high as $1000 worth of asset. But this can be very risky, as this can magnify your losses exponentially if you are using very high leverage.

Hence regulatory bodies keep a tight vigil over the leverage offerings by brokers, in order to protect the investor money. You should keep in mind the risk leverage brings along with it and should use it cautiously.

#2 Interest Rate Risks: A country’s interest rate is directly proportional to the strengthening of its currency due to inflow of investments in that country’s assets. A stronger currency provides high returns.

Simultaneously, if the interest rate falls, the investments are withdrawn, hence weakening the currency. Therefore, changes in interest rates, make the currency values fall or rise. Hence having an effect on the exchange rate of the currency pairs.

Since the decision on any economic decision by Central Banks is not in control of any investor, it can be very risky if you are trading during any such news.

#3 Counterparty & Broker Risk: Counter-party risk refers to the risk of default from either the dealer or broker in a transaction. In such cases, guarantee of completion of trade is at risk, generally arising from the solvency of the dealer.

Hence, choose a broker that is reputed like these Top tier regulated forex brokers in Nigeria that we have compared & listed.

#4 Country Risk: Country risk refers to the risk of investing into the currency of a country with weak economic conditions and having a risk of currency crisis. Such cases arise from huge deficits and debts on country, political instabilities and other such conditions which devalue the currency.

This is a major risk if you are investing in a weak exotic currency, that is not traded that much. Beginner currency traders should stick to majors, pairs with high liquidty.

Forex trading can give one the opportunity to earn profits, but you must understand the risks. You should do enough research and understand fully the risks that are involved and plan your trading activity accordingly.

Learning Forex Trading

We have created guides on various concepts of forex trading for beginner traders. You can read our guides to learn the basics.

Here are some more guides:

  1. What is leverage in Forex Trading?
  2. Best time to trade Forex in Nigeria?

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