How Forex Trading Works

How Forex Trading Works

Whenever you talk about the markets to your friends and family, they will generally assume that you’re talking about the stock market. In terms of ‘forex vs stocks‘ structure, the stock market is much different to the Forex market, let’s take a look and see how they differ in structure, and the advantages/disadvantages of each.

THE CENTRALIZED MARKET

Centralized markets operate through a ‘central’ exchange. This means any orders that are placed on a centralized market MUST go through its housing exchange. Doesn’t matter if you’re a large company with big pockets or just a small retail trader, whether you’re going long or short. Everything is processed through the central exchange.

Pros:

The ability to track all transactions

One cool thing centralized markets can do is track the amount of orders, and their volume at any given time with full accuracy. This allows centralized markets to provide more accurate analytic data of all the transactions that go through the central hub to their market participants. For example; the stock market offers true volume data, where the foreign exchange market cannot.

Cons:

You’re at the mercy of the central ‘market king’

When trading on the stock market, all your orders are executed through the exchange central hub, which has the ability to manipulate prices, increase market spreads and enforce short bans.

market crashScenario 1: There are more sellers than buyers in the market, and remember for every seller there must be a buyer, but let’s say there are no buyers left to facilitate a rapid amount of sell orders coming in. The central exchange will deliberately increase the market spread in an attempt to discourage more sellers from entering the market.

Scenario 2: Traders are spooked about an economic crisis, and want to sell off their stocks. First the central exchange raises the spread to discourage the traders from selling. However the traders are desperate to get rid of their stocks due to a progressing market crash and are not discouraged by the high spread prices. The selling pressure becomes overwhelming, so the exchange issues a short sell ban. Now no new short orders can be opened. Only traders currently holding stock are allowed to sell them, but generally there are no buyers during market crashes and traders have no choice but to watch their money disappear.

You can only trade when the central exchange is open

Trading hours in centralized markets are restricted to their exchange’s trading hours, which are typically the normal business hours of the exchanges time zone, Monday to Friday. The New York Stock exchange opens at 8am and closes at 5pm New York time. If you want to trade outside of those hours, tough luck, without the central exchange there is no one to facilitate your trade order.

THE DECENTRALIZED MARKET

Now let’s have a look at how Forex trading works by talking about the decentralized market. This is a market that doesn’t have one central exchange that controls all market activity. The decentralized market has many hubs and channels that interconnect with one another. Trade orders can take multiple paths to “make a trade”.

 

An example of a decentralized network is the internet. Internet signals from your computer have many possible routes to reach their destination. If the preferred route is blocked or not working, your signal is re-routed through the next best available route. The Forex market works in a very similar way.

The Foreign Exchange market is a decentralized network market; take a look at the model below to get a visual representation of how the market is connected together. The diagram below will give you a good visual representation on how Forex trading works.

The Foreign Exchange can be thought of as a network structure that operates on a tier system, the major banks located on the top tier, and us retail traders trading from our computers at homes are on the bottom tiers. So what happens to our trade when we place our order?

Tier 1: The Interbank Network

The interbank network contains the central and major banks, represented by all the black entities on the chart above. These guys are the core of the Foreign Exchange network. All orders must pass through one of the members of the interbank network to be executed. The guys on the interbank network are the ones with the money, and they provide the liquidity to the other market participants. This is the core of how Forex trading works, the interbank networks is the ‘glue’ that holds everyone together.

Tier 2: The market makers

You are connected to the internet right now reading this article. To get access to the internet you were required to sign up with an ‘internet service provider’, which you pay a service fee to, and they provide you with the means to browse the internet. The Foreign exchange is very similar, to be able to start making trades you need to sign up to a broker, the broker is your means to access the interbank network and start making trades with the rest of the world.

When you think about how Forex trading works, Brokers are the market makers. When you place a trade order, the broker will first try to match up your trade with another client of the brokers, bypassing the interbank network all together. If this is successful the broker now has a free hedge trade and is at no risk of loss. If the broker can’t match up the trade amongst its own clients, they will usually open a trade in the opposite direction to yours (a hedge trade) on the interbank network. This will protect the broker from any losses your trade may attract.

The market makers have access to the cheaper interbank network market prices; the market maker adds their commission onto the interbank pricing and passes that onto you. The difference in prices is called the ‘Bid-Ask spread’.