Foreign exchange, forex or FX mean the same thing – the global currency market where traders, banks and institutions exchange one currency for another and buy or sell currency pairs.
Forex is a unique beast and a market that moves very quickly, handles trillions of pounds of daily transactions and is the most liquid on the planet.
There is no governing body or centralized location, but you need a forex broker to take a position or make a trade.
The world’s largest securities market uses currency pairs, where one denomination is quoted at a price against the other, and traders use a variety of approaches, such as futures and forwards, to try to beat the market.
The Basics of Forex Markets
Market values dictate the daily value of a currency, known as the exchange rate.
Travel money distributors and banks use these exchange rates to determine how much you get when you spend your money in another currency at any given time or when you pay for something abroad or from a foreign supplier .
If you find that your holiday budget does not stretch that far, it is most likely because the British pound has weakened or the other currency has strengthened.
Traders use changing exchange rates to backtrack and guess which way a currency might move to try and profit. For example, if you think the Euro is about to skyrocket, you can buy that currency now and sell it back once the price has risen; if, of course, you end up being right.
The US dollar is the most influential currency in the forex market because it is the most actively traded. Common pairs include USD against GBP, AUD, JPY or EUR. Any currency pair that excludes the USD is called a cross, usually EUR/GBP or EUR/JPY.
Forex spot markets can move quickly and dramatically, and short-term traders use technical analysis to make decisions based on the currency’s trend and how fast it is.
Longer term foreign exchange trading is based on fundamental analysis such as GDP, economic circumstances and interest rates in each respective country.
Forex trading example
By way of illustration, a forex trader can anticipate that the European Central Bank is about to announce an easing of monetary policy in an attempt to prop up a struggling economy, causing the euro to fall against the US dollar.
If their expectations are correct, they sell €100,000 short at 1.15. The exchange rate drops to 1.10, which means the trader makes a profit of $5,000.
Because the trader sold €100,000 at 1.15, he hedged a trade worth $115,000. The euro depreciated, and buying back the same currency cost $110,000, resulting in a differential and a gain of $5,000.
If the trade was incorrect and the Euro had strengthened, they would have incurred a loss using the same calculation.
Forex currency pairs
Currencies are always listed in pairs, such as:
- USD/CAD: US dollars against Canadian dollars
- EUR/USD: euros against US dollars
- USD/JPY: US dollars against Japanese yen
Each pair has an associated price, so if the price of USD/CAD were 1.2569, it would cost $1.2659 in Canadian dollars for each USD.
Forex traders use lots, which are standardized blocks of currency trading volumes. A standard lot is 100,000 units, a mini lot is 10,000, a micro lot is 1,000 and a nano lot is 100 units.
For example, seven micro lots would mean a trade of 7,000 units, and seven standard lots would mean 700,000 currency units.
Currency markets use these trading blocks because the trading volume is large and averages around £5.91 trillion every 24 hours.
Often brokers won’t process trades smaller than a micro lot because the margins and trading costs aren’t worth it for such a small trade.
Although forex is decentralized and not controlled by any organization, the largest trading centers are Hong Kong, Tokyo, Singapore, New York and London.
How to Trade Forex
Forex markets do not close overnight and are open 24 hours a day, Monday to Friday, anywhere in the world.
Transactions are completely digital and placed through online brokers, and no real currency changes hands. Instead, you take a position against your selected currency depending on whether you think it will go up or down.
The market differs significantly from other investment markets.
Forex has few rules, although regulators in some countries may limit things like the maximum leverage ratio a regulated forex broker can offer. The market has no oversight body or clearing house.
Brokers tend to make their profits through spreads – the difference between quoted and actual currency prices – and low commissions and transaction fees.
Investors can buy as many currencies as they want as there are no upside limits on trade size and the market is very liquid.
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Types of Forex Trades
The three main forex trades are spot, forward and futures.
The spot market is the simplest option, with spot rates referring to the exchange rate at any given time. When you make a spot FX transaction, you are buying one currency with another at that rate.
Most spot trades settle within two business days, with the exception of USD/CAD, which settles the next business day.
The transaction is settled at the spot rate quoted when the transaction is initiated, regardless of how long it takes for the transaction to be finalized and the money exchanged.
Forward transactions mean that you create a transaction that will be settled at a later date. The quoted futures price combines the spot rate and all the futures points, plus or minus, representing the differential between current interest rates.
In forex, futures trades tend to mature in less than 12 months, but longer durations are available. Prices are fixed on the trade date, but no money changes hands until the end of the term.
Brokers customize futures trades to parties involved, which can be of any value, and settle on any date, as long as it is not a holiday or a weekday. -end in either country.
Futures contracts may look like futures, but they are the only type of forex trading that is done through an exchange – the Chicago Trade Exchange.
A forex futures contract is a derivative contract where the buyer and seller accept the transaction on a fixed date and for a fixed price.
International companies often use futures contracts to hedge against large currency fluctuations, where they use foreign currencies for their business dealings abroad, and speculators also use futures contracts to try to generate a profit.
The Risks and Benefits of Forex Trading
Forex was traditionally a market for financial institutions only, and the advent of online brokers, trading apps and digital accounts has transformed how it works.
Investors appreciate the low entry costs and the fact that the forex markets do not close like a conventional stock market with limited trading hours.
There are thousands of forex brokers, including those with demo accounts and educational resources for newbie traders.
The downsides are that forex is volatile and uncertain and can easily lose a lot of money, especially with high leverage trades. Professional and institutional traders use technology to predict price movements and analyze economic parameters that influence exchange rates.
It is a high risk market with significant competition. Traders need to act quickly when conditions change because a profitable position can quickly become much less profitable.
FAQ on how the foreign exchange markets work
What are currency pairs?
Currency pairs are two currencies that trade against each other – and there are hundreds of pairs to choose from, although most traders use the major currencies including EUR/USD, GBP/USD or USD /JPY.
What are base and quote currencies in FX?
Each forex trade has two prices depending on which currency you are buying and which currency you are selling.
The base currency is always on the left, which is considered a unit.
The currency quoted on the right is valued at the current market rate, so you must pay this price multiplied by the number of units of the base currency you wish to trade.
What are forex pips?
A pip is the fourth digit after the decimal in a forex price. For example, if you have a quote of 1.3536, the pip is six. Pips indicate the smallest margin that a currency price can change.
Why do forex markets use lots?
Lots are normalized trading volumes measured in units. A standard lot is 100,000 units of the base currency you are using. You can also trade mini, micro and nano lots with smaller volumes of currency units.
What is a forex margin?
Your margin is the deposit you make with a forex broker to open and maintain a position, and it also indicates the maximum leverage you can borrow.
For example, you might want to open a EUR/GBP trade with a margin of 3.33%, so you need to deposit £3,300 to open a position on one lot worth £100,000.
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