TradingKey - In April 2025, U.S. President Trump once again exerted pressure on Federal Reserve Chairman Powell, demanding an immediate reduction in interest rates. Trump's remarks heightened market expectations for a Fed rate cut, putting pressure on the dollar index. The British pound to U.S. dollar (GBP/USD) pair continued to rise amid fluctuations, showcasing strong overall performance.

Given such frequent market volatility, many novice investors who have gained a basic understanding of forex concepts from previous content are eager to jump in but are confused about practical operations. This article will explain the fundamental knowledge needed for trading in the forex market.

A currency pair (e.g., EUR/USD, GBP/USD, USD/JPY) consists of two currencies, each with a defined role:

Base Currency

The first currency in a pair is the base currency (e.g., EUR in EUR/USD). It serves as the reference point for the exchange rate. When the EUR/USD exchange rate rises, one euro can be exchanged for more US dollars, indicating that the euro is appreciating against the US dollar.

Quote Currency

The second currency in a pair is the quote currency (e.g., USD in EUR/USD). The exchange rate specifies how many units of the quoted currency are necessary to obtain one unit of the base currency. If the EUR/USD exchange rate is 1.1000, it means one euro can be exchanged for 1.1000 US dollars.

Direct Quotation

In a direct quotation, foreign currency is used as the reference point. This method determines how much domestic currency is required to purchase a specific unit of foreign currency.

Quotation Structure: It is presented as Bid/Ask (Buy Price/Sell Price), where:

Bid Price: The price at which banks buy the base currency (foreign currency) from customers (the amount customers receive when exchanging foreign currency for domestic currency).

Ask Price: The price at which banks sell the base currency (foreign currency) to customers (the amount customers pay when buying foreign currency with domestic currency).

Example: For USD/JPY quoted at 110.50/110.55:

Buying 1 dollar costs 110.55 yen (Ask Price—cost for customers purchasing dollars).

Selling 1 dollar yields 110.50 yen (Bid Price—revenue for customers selling dollars).

The spread, calculated as 110.55 - 110.50 = 5 pips, represents the broker's service fee and reflects an implicit cost to customers.

Indirect Quotation

In an indirect quotation, the domestic currency is utilized as the reference point.This method calculates how many units of foreign currency can be obtained for a specific amount of domestic currency.

Quotation Structure: Displayed as Bid/Ask as well, but with switched meanings:

Bid Price: The price at which banks acquire the base currency (domestic currency) from customers (the revenue customers receive when exchanging their domestic money for foreign funds).

Ask Price: The price at which banks sell the base currency (domestic money) to customers (the cost incurred by customers buying domestic funds using foreign money).

Example: For EUR/USD quoted at 1.1200/1.1205:

Selling 1 Euro results in receiving 1.1200 dollars (Bid Price—revenue from selling Euros).

Buying 1 Euro costs 1.1205 dollars (Ask Price—cost incurred to purchase Euros).

The spread, calculated as 1.1205 - 1.1200 = 5 pips, reflects transaction costs seen through the difference in exchange rates.

Economic Fundamentals: The Long-Term Anchor for Exchange Rates

Economic indicators play a vital role in determining the variations in exchange rates. These include economic growth, inflation rates, and interest rates.

• Economic Growth

A strong economy with rapid GDP growth attracts foreign investment, increasing demand for the country's currency and driving its value higher.

• Inflation Rate

A low inflation rate stabilizes prices and maintains the purchasing power of a currency, making it more attractive to investors and increasing its exchange rate. Conversely, elevated inflation diminishes purchasing power, deterring investors and leading to depreciation.

• Interest Rate Levels

Interest rate differentials (domestic interest rate minus foreign interest rate) act as a "short-term driver" of exchange rates and can stimulate arbitrage trading (known as Carry Trade). Higher interest rates attract foreign investors seeking better returns, increasing demand for the currency and strengthening its exchange rate.

Policy Factors: The "Dual Control" of Central Banks and Governments

• Monetary Policy

A primary tool of monetary policy is interest rate adjustment. When central banks raise interest rates, they attract domestic and foreign investors to deposit funds, increasing currency demand while reducing its circulation. This combined effect of rising demand and decreased supply enhances the currency's value, resulting in an appreciation of exchange rates.

Changes in money supply also significantly affect exchange rates. An increase in the money supply from central banks floods the market with currency, leading to a decline in its relative value and depreciation of the exchange rate. Excess currency chasing limited goods can trigger price increases and inflationary pressures, diminishing the currency's attractiveness. In contrast, reducing the money supply creates scarcity, raising its value and pushing exchange rates higher. For instance, Japan's prolonged quantitative easing policies have substantially increased money supply, contributing to a declining yen value on international markets.

• Fiscal Policy

Fiscal policy influences exchange rates through government spending and taxation. By increasing investment in infrastructure, education, and healthcare, governments can stimulate economic growth, create jobs, and enhance market vitality. Such economic prosperity attracts more investments—both domestic and foreign—thereby boosting demand for the domestic currency and elevating its exchange rate.

Tax policy adjustments also play a role. Lower taxes reduce burdens on businesses and individuals, increase disposable income, stimulate consumption and investment, positively impacting economic growth; conversely, tax increases can suppress economic activity by reducing currency demand and negatively impacting exchange rates.

Balance of Payments: The "Supply and Demand Equilibrium" of Exchange Rates

A surplus in the current account strengthens a currency.Japan has regularly achieved a current account surplus of about 4%. Even during the implementation of ultra-loose monetary policies under Abenomics, the yen continued to serve as a haven. In contrast, in 2022, the eurozone faced a trade deficit of €30 billion, which led to the euro falling to its lowest level against the US dollar in 20 years.

Geopolitics: The "Black Swan Incubator" for Exchange Rates

Geopolitical events act like a ticking time bomb, causing significant short-term fluctuations in exchange rates. When international tensions rise—such as during wars, political conflicts, or terrorist attacks—market uncertainty increases, severely shaking investor confidence. Consequently, investors instinctively withdraw funds from high-risk countries and shift them to those deemed politically stable and economically secure. This large-scale capital movement can drastically alter the supply and demand dynamics of currencies, leading to substantial exchange rate volatility.

Market Expectations and Investor Sentiment: The "Self-Fulfilling Mechanism"

Investor expectations about a country's economic prospects directly influence their currency trading decisions. Sentiment is often swayed by media reports and market rumors. When optimism is high, investors may overly buy the currency, leading to overvaluation; conversely, when sentiment turns negative, panic selling can result in undervaluation.

Essential Considerations for Forex Trading

Choosing Currency Pairs

The foundation of forex trading is selecting currency pairs based on their liquidity, volatility, and correlation.

Historical Data Analysis: Studying past exchange rate trends helps identify long-term volatility patterns. For example, the EUR/USD pair typically fluctuates between 80 and 120 pips daily, while the AUD/NZD pair can exceed 150 pips.

Influencing Factors: Monitor fundamental factors like economic data and policy shifts to predict currency movements. For instance, rising expectations of a Fed rate hike may boost USD/JPY due to higher interest differentials; Brexit-related news can notably affect GBP valuations.

Cost Control

Understanding and managing trading costs is crucial for maximizing profits.

Spread: The spread—the difference between buying and selling prices—represents a primary cost of trading. Profitability is achieved only when price changes exceed the spread. For example, if the EUR/USD spread is 1 pip (0.0001), the currency must move at least 2 pips for profit.

Fees: Some platforms charge additional fees on top of spreads, either as a percentage (e.g., 0.1%) or fixed amounts (e.g., $5 per lot). Comparing platforms’ spreads and fees helps identify the best options.

Risk Management

Leverage can enhance returns but also amplifies risks; effective risk management is essential.

Using Leverage: Choose leverage based on your risk tolerance. Using a leverage ratio of 1:100 allows for control over 100 with a 1 margin but also magnifies potential losses by the same factor. Beginners should commence trading with lower leverage (e.g., 1:20) to gradually build their experience.

Order Management: Setting take-profit and stop-loss orders aids in managing risk effectively. A take-profit order secures gains while limiting losses through stop-loss orders protects account equity from significant downturns. For instance, when buying EUR/USD, set a stop-loss 30 pips below entry and take-profit 50 pips above to balance risk and reward.

Capital Management: Limit each trade's investment to 2%-5% of total account equity to avoid overtrading, ensuring that even if trades incur losses, overall account health remains intact.