Forex trading is the term used for trading currencies against one another. (Forex is a combination of the words ‘foreign’ and ‘exchange’.)

Forex traders seek to profit from the price moves of one currency against another.

Let’s go through a forex trade example here:

Say the current exchange rate between USD and GBP is 1.2 ($1.20 for every £1.)

You buy $10,000 for £8,333. ($10,000/1.2 = $8,333.)

Over the following two days, the exchange rate changes to 1.1.

You sell your $10,000 back at the new exchange rate. In return, you receive £9,090.

Simply due to the change in rate, you now have £757 more than you started with. (£8,333 to £9,090.)

Had the rate changed the other way and moved to 1.3, you would have ended up with just £7,692. This would represent a loss of £640.

At a very basic level, this is how to trade forex.

Forex pairs

All forex trades are done in pairs. You always trade the value of one currency against another. This is the foundation of forex trading.

If you’ve already spent some time researching forex, you may have seen some currency pairs before. They look like this:

• EUR/USD
• GBP/USD
• USD/JPY
• AUD/USD
• USD/CAD
• USD/CNY

There are two currencies within a currency pair:

1. The first currency is known as the base currency.
2. The second currency is known as the quote currency.

When you trade forex, you always trade the value of the base currency against the quote currency.

So, if your pair is GBP/USD, you’re trading the value of the US Dollar against the British Pound.

In the USD/JPY pair, you’re trading the value of the US Dollar against the Japanese Yen.

And so on.

No matter what kind of forex trade you’re making and what method you’re using to trade, all forex trades work this way.

How can I get started trading forex?

There are two main methods for trading forex. Spot trading and CFD trading.

CFD spot trading

Spot forex trading means you simply buy and sell your currencies in cash, as in the example we described earlier.

You buy one currency using the other. Then, if the exchange rate moves in your favour, you can sell and take any profits. (Or cut your losses if the trade moves against you.)

(You can do spot trading online, without possessing the physical money. By ‘cash’, we simply mean that you don’t use leverage or any tools to amplify gains and losses. You buy and sell your currencies for the current cash value.)

CFD forex trading

CFDs are a form of derivative. This means that when you trade forex using CFDs, you don’t actually own the currencies. You simply speculate on how the prices will move.

CFD stands for ‘Contract for Difference’. When you open a CFD, you agree with a broker to exchange the difference between the price of an asset when you open the contract and the price when you close the contract.

Calculating profits and losses on forex CFDs is more complex than spot trading. It will likely take you a few run throughs to understand how it works. (Which is normal. Take your time!)

Let’s go through an example forex CFD trade now:

Let’s say the current price of USD/GBP is 1.13050 when you open the contract, and it moves to 1.14000 by the time you close the contract. Your points profit here is 95.

(Your points total is usually calculated on the last two decimal points. 1.14000 – 1.13050 = 0.0095. So, 95 points.)

The way to calculate your profit or loss is with this sum:

[Financial value of trade x price when trade opens] – [Financial value of trade x price when trade closes]

Let’s say our trade here is worth $10,000.

So, let’s go through the whole sum, bit by bit.

First, we multiply the size of the trade ($10,000) by the price of the asset when the trade opens (1.14000):

$10,000 x 1.140000 = $11,400

Then, we multiply the size of the trade ($10,000) by the price of the asset when the trade closes (1.13050):

$10,000 X 1.13050 = $11,305

Then, finally, we take the first answer ($11,400) and subtract the second ($11,305):

And then $11,400 - $11,305 = $95.

So, for this trade, your profit would be $95.

If the price of the contract had fallen, then the first answer would have been smaller than the second answer, taking you into a negative figure. (Which means you would have lost money.)

How do I calculate the size of my CFD trade?

With CFDs, the size of your trade is based on the number of contracts you open multiplied by the price of each contract.

Each contract is the price of the currency pair. So, if we used the same price from the previous example, each contract from that USD/GBP pair would be worth $1.14.

Let’s say you choose to open 2,000 contracts. This would mean your total trade size would be $2,280.

($1.14 x 2,000.)

If you chose to open 4,000 contracts, your total trade size would be $4,560. ($1.14 x 4,000.)

And so on.

CFDs and leverage

The primary difference between spot trading and CFDs, aside from the fact that you don’t actually own the currencies you’re trading when trading CFDs, is leverage.

Leverage allows you to access larger trades without having to supply all the money upfront.

So, if you’re spot trading and you want to open a $10,000 trade, you will need to have $10,000 (plus fees) to make the purchase.

If you use leverage, you can still place a $10,000 trade, but you won’t need to supply all the capital upfront.

There are a number of risks that come with using leverage, which we’ll go through in a minute. But firstly, let’s go through a quick example of how leverage works within a CFD trade:

Let’s say your broker will allow you leverage of 1:30.

To calculate your required upfront capital, you divide the value of the trade ($10,000 in this case) by the second, larger number in the leverage figure (30).

This means that to place this trade using leverage of 1:30, you’d need to supply $333 in upfront capital. (Plus your margin.)

When you use leverage, your profits and losses are calculated on the full value of the trade, rather than on the capital you actually put in.

So, if your trade value is $10,000, and you lose 20%, your loss would be $2,000. Even though you only actually put $333 of capital in.

In other words, when you use leverage, you can lose more money than you put in.

That’s why you should always make sure you thoroughly understand the risks of leverage and – most importantly – you should never trade with money you cannot afford to lose.

With spot trading, it is impossible to lose more than the total value of your trade, and even that would require one currency falling to zero in value against the other.

For this to happen, you’d be looking at complete currency collapse, which does happen but is (mercifully) rare.

Summing up

Forex trading involves trading the change in price between one currency and another in the form of a currency pair.

CFDs and spot trading are probably the most commont ways to approach forex trading by beginners, and both have their own benefits and risks.

Always conduct thorough research before any trade, and never trade with money you cannot afford to lose.