February 2, 2023
What Is Forex?
Forex, also known as Foreign Exchange or FX, is the process of converting one currency into another. Forex trading, however, involves buying and selling a range of currency prices to potentially make a profit. FX is one of the most actively traded markets in the world, with individuals, companies and major banking institutions carrying out large forex transactions every single day.
Whilst most foreign exchange is done for practical purposes such as holidays or travel, the vast majority of currency conversion is carried out by forex traders to earn a profit. The amount of currency converted each day can make the price movements of some currencies extremely volatile.
It is thought that a huge $6.6 million worth of forex transactions are made every single day.
What is the forex market?
Forex trading works like any other transaction where you are buying an asset and selling it. The market price will make a trader aware of how much of one currency is needed to purchase another (each currency has its own 3-letter ISO code which lets traders identify it i.e. USD, United States Dollar or JPY Japanese Yen.)
Currencies are traded in pairs, so by exchanging one currency for another traders are speculating on whether one currency will rise or fall in value against the other.
An FX pair is a combination of two currencies that are traded against each other. There are thousands of different combinations to choose from but some of the most common ones include the Euro (EUR) against the dollar (USD) or the pound (GBP) against the dollar (USD) and also the dollar (USD) against the yen (JPY).
What are base and quote currencies?
A base currency is always on the left of a currency pair and the quote is always on the right. The base currency is always equal to one, and the quote currency is equal to the current quoted price of the pair based on the market value that day. The quote currency will tell you how many of the quote currencies you will need to buy one of the base currency. For example, 1 EUR = 1.07630 USD, which means that one Euro is currently equivalent to 1.07 US Dollars.
To buy a currency pair means that you are expecting the price to rise, meaning that the base currency will strengthen relative to the quote currency. If you are selling a currency pair then you are expecting the price to decrease, meaning that the base currency will weaken in comparison to the quote currency.
Traders buy forex pairs to profit from one currency strengthening or weakening against another. When the price of a pair is rising that means it is strengthening against the quote currency and when the price is falling that means the base currency is weakening against the quote price. This is because a raising price means that more of the quote currency is needed to buy a unit of the base currency. A falling price means that less of the quote currency will be needed to buy one unit of the base currency.
A brief history of the forex market and foreign exchange
The forex market started centuries ago, people have always exchanged or traded goods and currencies to purchase goods and services. However, the forex market as we know it today is mostly a modern invention. When the Bretton Woods accord collapsed in 1971 currencies were able to float freely against one another. The values of individual currencies started to vary based on supply and demand and circulation is monitored by foreign exchange trading services.
Why are currencies considered to be assets?
There are a few reasons that currencies are now considered to be an asset class. Firstly, an investor can profit from the difference between two interest rates in two different economies by buying the currency with the higher interest rate, and secondly, You can profit from changes in the global exchange rates that can sometimes change or alter on a day-to-day basis.
Help from the internet
Currency trading, although not unheard of, was much more difficult before the invention of the internet. Most currency traders are large multinational corporations, hedge funds or high-net-worth individuals (HNWIs) because FX trading requires a lot of capital invested upfront. The internet allowed individual traders to easily gain access to the foreign exchange markets through either the banks or brokers making a secondary market to trade in
What do forex traders do?
FX traders anticipate changes in currency prices and take trading positions with currency pairs on the foreign exchange markets to profit from a change in currency demands. They execute trades for financial institutions, on behalf of clients or as individuals.
Is forex trading good for beginners?
FX trading can be complex and at times, difficult, so it may not be suitable for everyone. It will depend on your financial situation, your goals and how much investing experience you already have as a beginner. Beginners must be careful especially as the majority of forex traders lose money.
Different types of forex markets
There are plenty of ways to trade forex, including trading forex in multiple different markets.
Spot market - This lets you trade forex pairs at their current market price with no fixed dates. Spot markets deal with transactions in the present and these trades can take up to two days to finalise.
Forwards and Future Markets - A forward contract is a private agreement between two parties to buy currencies at a future date and at a predetermined price. A futures contract is an agreement between two parties to take delivery of a currency at a future date and at an agreed-upon price.
The spot market is where currencies are bought and sold at their trading price. That price is determined by supply and demand and is calculated based on lots of different factors such as current interest rates, economic growth and ongoing sociopolitical situations both locally and globally. Forex trading in the spot market is the most popular type of trading.
In the forwards markets contracts are purchased and sold between two parties who set the terms and conditions between themselves. In the futures markets, futures contracts are bought and sold based on the standard size and final date on public commodity exchanges.
Both types of contracts are binding and typically settle for cash at the exchange in question when the contract ends. Although contracts can also be bought and sold before expiration. Forwards and Futures contracts can offer protection against risk when trading currencies as you have a say in setting the initial terms.
In the UK, the Financial Conduct Authority (FCA) regulates the futures market. Futures contracts have specific details including the number of units traded, delivery and final settlement costs and dates. They also include minimum price increments that can’t be customised.
How is the forex market broken down?
The forex market is open 24 hours a day thanks to the global banking systems that are constantly exchanging currencies. The main trading locations are the US, Europe, and Asia and the time differences between these locations allow the FX market to be open for 24 hours. These hours usually vary when different countries shift into daylight savings times on different days.
Forex market hours
10am-8pm - Asia-Pacific Countries
7am-4pm - European countries
12pm-9pm - North-American Countries
These flexible hours are attractive as they offer traders the ability to grab opportunities around the clock. Some FX providers allow weekend trading on some currency pairs which means that you could take advantage of these hours when other traders can’t.
What are the main uses of forex markets?
The two main uses of the FX markets are speculating and hedging. Speculating describes traders taking maximum advantage of fluctuations in the markets, speculators will usually buy and sell currencies in volatile markets and are exposed to high risk due to educated guesses as to when prices are likely to rise and fall. For example, if a speculator thinks that a stock is overpriced, they may sell short the stock and wait for the price to decline, at which point it can be bought back for a profit.
Hedging is a way to reduce your exposure to risk by opening positions that will return a profit if your other positions start to lose value. For example, hedging traders will use currency correlations to navigate the FX market, EUR/USD and GBP/USD are positively correlated because their economic markets usually move in similar ways based on the international trading of goods and services. So a hedge would be to open a short position for GBP/USD and a long position for EUR/USD to try to outsmart any potential market declines.
Opening a short position involves borrowing a security whose price you think is going to fall and selling it on the open market. Your plan is to then buy the same stock back later, hopefully for a lower price than you initially sold it for, and pocket the difference after repaying the initial loan.
Opening a long position means that you own the security. Investors maintain long positions in the expectation that the currency price will rise in value in the future.
What is a forex broker?
A forex broker provides access to trading platforms that can be used to buy and sell currencies giving you access to the forex trading markets. Forex brokers charge a fee and will traditionally buy and sell currencies on your behalf. However, online trading now gives anyone access to a trading platform meaning that you are able to buy and sell currencies yourself.
Costs and fees will vary from broker to broker but you will often be trading currency with leverage, which will help to reduce the initial amount of money that you'll need to open a position on the FX market. Leverage can increase your profits and also your losses.
How do currency markets work?
Central banks, news reports and market sentiments all help to move the forex markets. As the FX market is made up of currencies from all over the world it can make change predictions tricky as there are lots of different factors that can affect the market price movements.
Central Banking Institutions
A central bank is responsible for controlling the currency supply and they can announce measures that could have a significant impact on the market price of a currency. If a bank decides to inject money into an economy this can cause a currency price to fall due to an increased supply and demand. This is known as quantitative easing.
News Reports
Banks and other investors and traders want to make sure that they are putting their money into economies that look strong. If a piece of news is broadcast in a certain region and it is positive, it can encourage traders to invest, and therefore will increase the demand for that currency. If the news is negative, however, the demand for that currency may fall reflecting the economic health of that country.
Market Sentiments
If traders believe that a currency is heading in a certain direction due to the news reports they will trade accordingly and could therefore convince other traders to do the same which can cause fluctuations in demand for a certain currency.
Foreign exchange trading - key terminology
A forex account - This is used to make trades on currencies in the forex markets. Depending on the lot size, there can be 3 types of forex accounts:
- Micro FX Accounts - Allowing traders to make trades up to £10,000 worth of currencies in one lot.
- Mini FX Accounts - Allowing traders to make trades up to £10,000 worth of currencies in one lot.
- Standard FX Accounts - Allowing traders to make trades up to £100,000 worth of currencies in one lot.
An Ask/An offer - This is used to make trades on currencies in the forex markets. Depending on the lot size, there can be 3 types of forex accounts:
A bid - The price that you are willing to sell a currency at.
A pip - In forex trading, a pip is usually a single-digit movement in the fourth decimal place of a currency pair. For example, if USD/GBP moves from £1.35361 to £1.35371 then it has moved a single pip. If you’re trading in JPY a pip is a change at the second decimal point. A movement at the fifth decimal place is referred to as a pipette. Pip stands for percentage in point or price interest point.
A lot - Currencies are traded in lots, which are batches of currency that are used to standardise FX trades. As forex price movements are quite small, lots are usually very large. A standard lot is 100,000 units of the base currency. Lot sizes can vary from standard, mini and micro depending on the type of forex account you have set up. The bigger the lot size the higher the profits and losses.
The spread - The spread is the difference between the buy and sell prices or the bid and ask prices. For example, if the buy price is £1.3428 and the selling price is £1.3424 to make a profit you need the market price to either rise above the buy price or fall below the selling price.
Leverage - Leverage is the use of borrowed money to multiply your returns on investment. The trading limit for each lot includes margin money used for leverage, this means the broker can provide you with capital in a predetermined ratio. For example, they could put in £100 for every £1 you put in for trading meaning you will only need £10 from your own funds to trade currencies worth £1000.
Margins - Margins refer to the initial deposit you need to commit to in order to open and maintain a leveraged position in the FX market so trade on EUR/GBP may require a 3.33% margin to be opened. As a result, instead of needing £100,000 to open a position, you would only need to deposit £3,300. Margin money helps assure a broker that the trade will remain solvent even if it fails to fall in their favour.
Gaps - Gaps are points in a market when there is a sharp movement up or down with little or no trading in between resulting in a ‘gap’ in the usual price pattern. Gaps occur but they are less common than in other trading markets because the FX market is open 24 hours a day, five days a week. Gapping can also occur when economic data is released that comes as a shock or a surprise to the forex market, or when trading resumes after a holiday or over the weekend period. It is possible that the opening prices on a Sunday evening will be different from the closing price on the last Friday evening, resulting in a gap. This is because over the weekend banking institutions still have access to trading in the forex market.
Bear market - A bear market describes a market where currency prices decline for all currencies.
Bull market - A bull market describes a market where currency prices rise for all currencies.
Contract for difference (CFD) - A CFD is a derivative contract that enables traders to speculate on price movements for currencies that they don’t currently own.
Sniping and hunting - Refers to the sale of currencies near predetermined points to maximise profits.
How do I start FX trading?
There are many different ways to start trading in forex markets, you can get started with a forex trading account but you will need to be familiar with what moves the market and manage your risk appropriately. You can make money from forex trading by correctly predicting a currency pair’s price movements, and opening a position that may profit.
Retail investors should take the time to learn about the forex markets and then research which broker is the best to open an FX trading account with. You should also find out whether your broker is regulated in the US or the UK or by a country that has fewer rules. It is a good idea to find out what type of account protections are available in case of a market crisis or if your broker becomes insolvent.
Learn about forex trading.
Set up a broker account to allow you to access the forex trading markets.
Develop a forex trading strategy.
Check your positions at the end of each day to ensure that you don’t have any pending positions to be filled out.
What types of forex trading strategies can I use?
Some of the most successful trading strategies include scalping, day trading, swing trading, trend trading and position trading. You will likely choose your trading strategy based on whether you have a short or long-term outlook.
Scalping
Day Trading
Swing Trading
Trend Trading
Position Trading
Pros and cons of forex trading
Pros
FX markets are the largest in the world when it comes to daily trading volume and therefore offer the most liquidity. This makes it easy to enter and exit a position in any currency.
Forex is the most traded financial market in the world, which means that FX prices constantly change which creates more opportunities to trade.
The forex market is traded in 24 hours a day, five days a week offering several opportunities to make a profit or cover losses.
Extensive use of leverage in the forex markets means you can start trading currencies will little capital and multiply your profits.
FX markets are the largest in the world when it comes to daily trading volume and therefore offer the most liquidity. This makes it easy to enter and exit a position in any currency.
The forex markets follow the same rules as regular trading and require much less initial investment so it is easier to begin than stock trading.
If you are aware of the risks and take appropriate steps to mitigate your exposure forex trading can be your next opportunity.
Cons
Liquid markets are much more volatile than regular markets.
Extreme use of leverage can lead to dealers becoming unexpectedly insolvent.
Banks, brokers and dealers allow high leverage which means that traders can often control quite large positions with very little capital.
Forex trading requires an understanding of foreign currency and foreign economics
Some forex pairs are more volatile than others. Those with low liquidity are often the most volatile.
Pairs that include USD are often more liquid because the USD is the world's reserve currency and is often in high demand because of this.
Pairs that include USD are often more liquid because the USD is the world's reserve currency and is often in high demand because of this.
Forex trading - essential knowledge
The foreign exchange market also known as the forex market or the FX market is a global marketplace for buying and selling international currencies. Because of the international reach of the trade the FX markets are the largest trading markets in the world.
Currencies trade against each other as exchange rate pairs. Market traders use forex markets to hedge against international currency and interest rate risk, to speculate on geopolitical events among a variety of regions.
Frequently asked questions
Is there a difference between forex trading and currency trading?
There is no difference between FX trading and currency trading as both mean you are exchanging one currency for another. When forex trading or currency trading you are attempting to earn a profit by speculating on whether the price of a currency pair will rise or fall.
Is forex income taxable?
The tax on forex positions depends on which financial institution you are using to access the trade markets. When you trade via a forex broker or through CFDs any profits are taxable. However, your losses are tax-deductible, and depending on your circumstances they can also be used to offset gains made elsewhere. Alternatively, spread bets are a tax-free way to speculate on the forex market.
How is the forex market regulated?
Despite its size, the is very little regulation because there is no governing body to police the market at all times. Instead, there are several international trading bodies that supervise domestic forex trading as well as other markets to ensure that all forex providers are adhering to certain standards. In the UK the regulatory board is the Financial Conduct Authority (FCA)
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