The foreign exchange market (nicknamed forex or FX) is the market for exchanging foreign currencies. Forex is the largest market in the world and the transactions that take place there affect everything from the price of clothes imported from China to the amount you pay for a margarita while on vacation in Mexico.

What is Forex Trading?

In its simplest form, forex trading is similar to the currency exchange you might do when traveling abroad: a trader buys one currency and sells another, and the exchange rate constantly fluctuates depending on the currency. supply and demand.

Currencies are traded on the foreign exchange market, a global market open 24 hours a day from Monday to Friday. All currency trading is done over-the-counter (OTC), meaning there is no physical exchange (as there is with stocks) and a global network of banks and other financial institutions oversee the market (instead of a central exchange, such as the New York Stock Exchange).

A large majority of trading activity in the forex market occurs between institutional traders, such as people who work for banks, fund managers, and multinational corporations. These traders do not necessarily intend to physically take possession of the currencies themselves; they can simply speculate or hedge against future exchange rate fluctuations.

A forex trader can buy US dollars (and sell euros), for example, if he thinks the value of the dollar will strengthen and therefore be able to buy more euros in the future. Meanwhile, a US company with Indian operations could use the foreign exchange market as a hedge against rupee weakness, meaning the value of their income earned there would fall.

How currencies are traded

All currencies are assigned a three-letter code, much like the ticker symbol for a stock. Although there are more than 170 currencies in the world, the US dollar is involved in the vast majority of currency exchanges, so it is particularly useful to know its code: USD. The second most popular currency on the foreign exchange market is the euro, the currency accepted in 19 countries of the European Union (code: EUR).

The other major currencies, in order of popularity, are: Japanese Yen (JPY), British Pound (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), Swiss Franc (CHF) and Neo Dollar. -zeelandish. (NZD).

All currency exchanges are expressed as a combination of the two currencies traded. The following seven currency pairs, called the majors, account for approximately 75% of trade in the forex market:

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

How are Forex trades quoted

Each currency pair represents the current exchange rate of the two currencies. Here’s how to interpret this information, using EUR/USD (or the Euro-Dollar exchange rate) as an example:

  • The currency on the left (the euro) is the base currency.
  • The currency on the right (US dollars) is the quote currency.
  • The exchange rate represents the amount of quote currency needed to buy 1 unit of the base currency. As a result, the base currency is always expressed in 1 unit while the quote currency varies depending on the current market and the amount needed to buy 1 unit of the base currency.
  • If the EUR/USD exchange rate is 1.2, it means that €1 will buy $1.20 (or, in other words, it will cost $1.20 to buy €1).
  • When the exchange rate goes up, it means that the base currency has increased in value against the quote currency (because 1€ will buy more US dollars) and vice versa, if the exchange rate goes down, it means that the currency base has lost value.

A quick note: currency pairs are generally presented with the base currency first and the quote currency second, although there is historical convention on how certain currency pairs are expressed. For example, USD to EUR conversions are listed in EUR/USD, but not in USD/EUR.

Three Ways to Trade Forex

Most forex trading is not done for the purpose of exchanging currency (as you would when exchanging currency while traveling), but rather to speculate on future price movements, a bit just like you would with stock trading. Similar to stock traders, forex traders attempt to buy currencies that they believe will rise in value relative to other currencies or dump currencies that they anticipate will decline in purchasing power.

There are three different ways to trade forex, which will suit traders with different goals:

  • The spot market. This is the main foreign exchange market where these currency pairs are traded and exchange rates are determined in real time, based on supply and demand.
  • The futures market. Instead of executing a trade now, traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed amount of currency at a later date.
  • The futures market. Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate on a future date. This is done on an exchange rather than privately like the futures market.

Futures and futures markets are primarily used by forex traders who wish to speculate or hedge against future price changes of a currency. The exchange rates on these markets are based on what happens in the spot market, which is the largest of the forex markets and where the majority of forex transactions are executed.

Forex Terms to Know

Each market has its own language. These are words to know before engaging in forex trading:

  • Currency pair. All forex transactions involve a currency pair. Besides the majors, there are also less common transactions (like exotics, which are currencies from developing countries).
  • Seed. Short for percentage points, a pip refers to the smallest possible price change within a currency pair. Since forex prices are quoted to at least four decimal places, one pip equals 0.0001.
  • Bid-ask spread. As with other assets (like stocks), exchange rates are determined by the maximum amount buyers are willing to pay for a currency (the supply) and the minimum amount sellers require to sell (the demand). . The difference between these two amounts, and the value at which trades will ultimately be executed, is the bid-ask spread.
  • Ground. Forex is traded by what is called a lot, or standardized currency unit. The typical lot size is 100,000 currency units, although there are also micro (1,000) and mini (10,000) lots available for trading.
  • Leverage. Due to these large lot sizes, some traders may not be willing to put down that much money to execute a trade. Leverage, another term for borrowing money, allows traders to participate in the forex market without the otherwise required amount of money.
  • Margin. However, trading with leverage is not free. Traders must deposit money in advance as a deposit or what is called margin.

What Moves the Forex Market

Like any other market, currency prices are set by supply and demand from sellers and buyers. However, other macroeconomic forces are at play in this market. The demand for particular currencies can also be influenced by interest rates, central bank policy, the pace of economic growth, and the political environment of the country in question.

The forex market is open 24 hours a day, five days a week, giving traders in this market the opportunity to react to news that may not affect the stock market until much later. Because much of currency trading focuses on speculation or hedging, it is important for traders to be aware of the dynamics that could cause currencies to rise sharply.

Forex Trading Risks

Since forex trading requires leverage and traders use margin, forex trading has additional risks compared to other types of assets. Currency prices fluctuate constantly, but at very small amounts, which means traders have to execute large trades (using leverage) to make money.

This leverage is great if a trader makes a winning bet as it can magnify profits. However, it can also amplify losses, even exceeding the original amount borrowed. Additionally, if a currency loses too much value, leverage users open themselves up to margin calls, which may force them to sell their securities purchased with borrowed funds at a loss. Apart from possible losses, transaction costs can also add up and possibly hurt what was a profitable trade.

On top of all this, you should keep in mind that those who trade foreign currencies are small fish swimming in a pond of skilled and professional traders – and there could be potential fraud or confusing information. among new traders.

Maybe it’s a good thing that forex trading is not so common among individual investors. In fact, retail trading (i.e. trading by non-professionals) accounts for only 5.5% of the entire global market, according to figures from DailyForex, and some of the major brokers in online don’t even offer forex trading. Moreover, of the few retail traders who engage in forex trading, most find it difficult to make a profit with forex. CompareForexBrokers found that on average 71% of FX retail traders lost money. This makes forex trading a strategy that is often best left to professionals.