How Forex Trading Works
Last updated on March 12th, 2015
If you have ever taken a vacation out of the country, you already have an idea about how Forex trading works. Say you have booked a vacation to Europe and you are based in the United States. You want to change $1000 U.S. dollars (the Greenback) to Euros (the Euro) and you take your money to your local bank.
- You want to sell your U.S. dollar and buy the Euro
- Bank quotes current exchange rates such as $1 U.S = .74 Euro
- You receive 740 Euros.
For people looking to learn about Foreign Exchange trades, this transaction can be confusing. One of the easiest ways to understand how Forex trading works is to simply think:
You are buying (selling) one currency pair by selling (buying) it using another currency pair. For example: EURUSD
While other markets have a centralized exchange such as the CBOT and CME, Foreign Exchange trades take place in a non-centralized market. The means that you can trade anywhere as long as you have a counterparty for the transaction. For years, transactions took place on the “interbank market” which was reserved for banks, other institutions and those with large capital worth. The little guy, like you and I, were unable to take advantage of this market on a bigger scale. Understand though that while there is not a “central” exchange, they are exchanges all over the world. Ever see the currency kiosks in an airport? That is a currency exchange.
Exchanges Are Independent
Taking our airport kiosk example, say for a moment that there are two kiosks in the same building. Because there is no centralized exchange, each kiosk will have its own rules and prices. One kiosk may give you .76 Euros for $1 USD while the other will give you .74 Euros. Yes, it pays to shop around.
This is where it gets confusing when people learn about Foreign Exchange trades. In the kiosk, anybody can walk up and exchange their currency. You don’t have to wait for a counterparty to accept your offer at the quoted price. At the higher levels of the “interbank market”, the transactions are completed at the best bid/ask prices available. The differences between the buy/sell price is small and truly reflects the proper pricing of the currencies. The downside is much the same as trading stocks. There is only so much available at a certain price so orders may be filled with slippage. You need someone to buy what you are selling and at times, there is nobody willing to at the current price.
How Retail Traders Trade
Traders, such as you and I, deal with the “dealer” model type of exchange. To keep this simple, let’s return to our airport kiosk. As you approach the desk, you notice a list of currencies such as the EURUSD posted on a window.
They will sell you 1 Euro for every $1.3530 USD you give them.
You hand over the money and they give you the corresponding amount. They are the ones that provided liquidity for your trade. What you usually see is this: 1.3528/30. This is the price quoted as bid/ask. They will sell you 1 Euro for $1.3530 USD but will only buy the Euro from you for $1.3528. See the .0002 difference? That is spread cost and that is how they make their money. When you learn about Foreign Exchange trades, you will hear there is no commission. That is true however you do pay a spread cost which is the difference between the bid and ask price.
How Does It Work Online
Now imagine you are sitting in front of the computer and you are hooked up via internet to that kiosk. After you have learn how Forex trading works, you decide to execute a trade using an online forex trading system. Your trading system has shown you a buy in the EURUSD currency pair.
You want to buy the Euro with USD and the current price is 1.3060. You place an order and the kiosk instantly does the exchange for you. You have now bought a number of EURO dollars using the USD.
In reality, you will not trade with a kiosk. You will trade with many of the retail brokers that offer online trading. Once you learn how Forex trading works, you will want to shop around for your broker. The broker is actually a dealer and they will be the ones on the opposite side of your trade. This means when you buy the Euro as in this example, they bought the USD from you. 99% of the time, you will be filled at the exact quoted price. You must trade at the quoted price that the dealer has made. Yes, the dealer has stated the exchange price!
Trading With A Dealer
They are a few advantages to this type of setup for the average trader.
- Easy entry into the trading world for virtually anybody
- Can trade at any hour of the day without worry about liquidity. Although you may pay a slightly higher spread cost
- Many dealers will help you learn about Foreign Exchange trades
- Can control a large position with small margin due to leverage offered by the dealer
There are some downfalls however regulations have helped turn the page on “bucket shops” there were designed to rip off retail traders. How Forex trades work in today’s world is much different than it was years ago.
There is more to talk about when learning how Forex trading works. For example, why dealers hedge their positions and what causes them to widen the spread cost on each trade. Higher spread costs increases your cost on the trade. For those of you that want to learn about Foreign Exchange trades in great deal including the “behind the scenes” work, there is quite a bit of reading material on the internet. It is not needed to profit from Forex and is more of an academic exercise.
I have given you the basics of how Forex trading works but you will learn much more by actually getting involved in the markets and that usually starts with finding a trading system that trades Forex.
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