How Does Forex Trading Work? A Step-by-Step Explanation

Step 1: Pick a currency pair

Every trade involves a currency pair. The quote tells you how much of the second currency (the quote currency) one unit of the first (the base currency) costs. EUR/USD at 1.0850 means €1 = $1.0850.

Step 2: Decide on a direction

• Buy (go long) if you expect the base currency to strengthen — the pair’s price to rise.
• Sell (go short) if you expect it to weaken — the price to fall.

Selling a pair you do not own is normal in forex, because every trade is both a purchase and a sale. See long and short positions.

Step 3: Choose a position size

Positions are measured in lots: a standard lot is 100,000 units of the base currency, a mini lot 10,000 and a micro lot 1,000. Position size determines how much each pip of movement is worth.

Step 4: Open the trade — and pay the spread

Your broker quotes two prices: the bid (where you can sell) and the ask (where you can buy). The difference is the spread. Because you buy at the ask and would close at the bid, a new position usually shows a small loss equal to the spread as soon as it opens. On commission-based (“raw spread”) accounts the spread is smaller, but a commission is charged per trade instead.

Step 5: Close the trade

You close by doing the opposite: selling what you bought, or buying back what you sold. Your result is the price change multiplied by your position size.

Worked example

You buy 0.5 lots (50,000 units) of EUR/USD at 1.0850 and close at 1.0900 on a USD account.

1. Price change: 1.0900 − 1.0850 = 0.0050 (50 pips)
2. Profit: 0.0050 × 50,000 = $250, before costs

Had the price fallen to 1.0800 instead, the loss would have been $250.

Try your own numbers with the forex profit calculator.

The role of leverage and margin

Retail brokers let you open positions larger than your deposit by using leverage. The part of your balance set aside to hold the trade is called margin. Leverage magnifies losses exactly as much as gains. If losses reduce your equity too far relative to the margin in use, the broker first warns you — a margin call — and, if the margin level keeps falling to the stop-out level, closes positions automatically. That forced closing is called a stop out or margin close-out.

Trading costs

• Spread: the gap between bid and ask.
• Commission: some account types charge a fee per lot instead of, or on top of, a wider spread.
• Overnight swap (rollover): a financing charge or credit for positions held past the broker’s daily cut-off — see overnight swaps and rollover. This is a retail account charge, not the same thing as the FX swap contracts that banks trade with each other.

Who is on the other side?

Retail traders do not trade directly on the interbank market. Your broker either takes the other side of your trade itself or passes it on to banks and other liquidity providers. The CFTC reminds retail traders that when trading off-exchange forex, the dealer is typically the counterparty and controls the trading platform and prices — one reason to use a properly regulated broker.