Forex (FX): How Trading in the Foreign Exchange Market Works (2024)

What Is the Forex or FX?

The foreign exchange market, commonly referred to as the Forex or FX, is the global marketplace for the trading of one nation's currency for another.

The forex market is the largest, mostliquid marketin the world, withtrillions of dollarschanging hands every day. It has no centralized location, and no government authority oversees it.

Rather, the forex is an electronic network of banks, brokerages, institutional investors, and individual traders (mostly trading through brokerages or banks).

Understanding the Forex

The Forex market determines the day-to-day value, or the exchange rate, of most of the world's currencies. If a traveler exchanges dollars for euros at an exchange kiosk or a bank, the number of euros will be based on the current forex rate. If imported French cheese suddenly costs more at the grocery, it may well mean that euros have increased in value against the U.S. dollar in forex trading.

Forex traders seek to profit from the continual fluctuations of currency values. For example, a trader may anticipate that the British pound will strengthen in value. The trader will exchange U.S. dollars for British pounds. If the pound then strengthens, the trader can do the transaction in reverse, getting more dollars for the pounds.

Currency Pairs

In forex trading, currencies are listed in pairs, such as USD/CAD, EUR/USD, or USD/JPY. These represent the U.S. dollar (USD) versus the Canadian dollar (CAD), the euro (EUR) versus the USD, and the USD versus the Japanese yen (JPY).

There will also be a price associated with each pair, such as 1.2569. If this is the USD/CAD pair, it means that it costs 1.2569 CAD to buy one USD. If the price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has increased in value against the CAD, so it now costs more CAD to buy one USD.

In the forex market, currencies trade inlots, called micro, mini, and standard lots. A micro lot is 1,000 worth of a given currency, a mini lot is 10,000, and a standard lot is 100,000. Trades take place in set blocks of currency. For example, a trader can exchange seven micro lots (7,000), three mini lots (30,000), or 75 standard lots (7,500,000).

Trading volumein the forexmarket is generally verylarge. Trading in the foreign exchange markets averaged $6.6 trillion worth per day in April 2019, according to the Bank for International Settlements.

The largest trading centers are London, New York, Singapore, Hong Kong, and Tokyo.

Trading in the Foreign Exchange Market

The Forex market is open 24hours a day, five days a week around the globe.

Historically, foreign exchange market participation was for governments, large companies, andhedge funds. In today's world,trading currencies is as easy as a click of a mouse and accessibility is not an issue. Manyinvestment companies allow individuals to open accounts and trade currencies through their platforms.

This is not like a trip to a foreign exchange kiosk. The process is entirely electronic with no physical exchange of money from one hand to another.

Rather,tradersare taking a position in a specific currency in the hope that there will be some upward movement and strength in the currency that they're buying (or weakness if they're selling) so that they can make a profit.

Forex Market vs. Other Markets

There are some fundamental differences between foreign exchange and other markets.

First of all, there are fewer rules, which means investors aren't held to strict standards or regulations like those in the stock, futures, andoptions markets. There are noclearing housesand no central bodiesthat overseethe forex market.

Second, since trades don't take place on a traditional exchange, there are fewer fees orcommissionslike those on other markets.

Next, there's no cutoff as to when you can and cannot trade. Because the market is open 24 hours a day, you can trade at any time.

Finally, because it's such a liquid market, you can get in and out whenever you want and you can buy as much currency as you can afford.

Types of Forex Transactions

Forex traders transact in one of three distinct marketplaces: the spot, the forward, or the futures market. To find the best entry and exit point for a trade, they will use a variety of analysis techniques.

The Forex Spot Market

The spot market is the most straightforward of the Forex markets. The spot rate is the current exchange rate. A transaction in the spot market is an agreement to trade one currency for another currency at the prevailing spot rate.

Spot transactions for most currencies are finalized in two business days. The major exception is the U.S. dollar versus the Canadian dollar, which settles on the nextbusiness day.

The price is established on the trade date, but money is exchanged on thevalue date.

Role of the U.S. Dollar

The U.S. dollar is the most actively traded currency. The most common pairs are the USD versus theeuro, Japanese yen, British pound, and Australian dollar.

Trading pairs that do not include the dollar are referred to as crosses. The most common crosses are the euro versus the pound and the euro versus the yen.

The spot market can be very volatile. Movement in theshort termis dominated by technical trading, which bases trading decisions on a currency's direction and speed of movement. Longer-term changes in a currency's value are driven by fundamental factors such as a nation's interest rates and economic growth.

The Forex Forward Market

A forward trade is any trade that settles further in the future than a spot transaction. Theforward priceis a combination of the spot rate plus or minus forward points that represent theinterest rate differentialbetween the two currencies.

Most forward trades have a maturity of less than a year in the future but a longer term is possible. As in the spot market, the price is set on the transaction date but money is exchanged on the maturity date.

Aforward contractis tailor-made to the requirements of the counterparties. They can be for any amount and settle on any date that is not a weekend orholiday in one of the countries.

Forex Futures

Unlike the rest of the foreign exchange market, forex futures are traded on an established exchange, primarily the Chicago Mercantile Exchange.

Forex futures are derivative contracts in which a buyer and a seller agree to a transaction at a set date and price.

This type of transaction is often used by companies that do much of their business abroad and therefore want to hedge against a severe hit from currency fluctuations. It also is subject to speculative trading.

Example of a Forex Trade

A trader thinks that the European Central Bank (ECB) will be easing its monetary policy in the coming months as the Eurozone’s economy slows. As a result, the trader bets that the euro will fall against the U.S. dollar and sells short €100,000 at an exchange rate of 1.15. Over the next several weeks the ECB signals that it may indeed ease its monetary policy. That causes the exchange rate for the euro to fall to 1.10 versus the dollar. This creates a profit for the trader of $5,000.

By shorting €100,000, the trader took in $115,000 for the short sale. When the euro fell, and the trader covered the short, it cost the trader only $110,000 to repurchase the currency. The difference between the money received on the short sale and the buy to cover it is the profit.

Had the euro strengthened versus the dollar, it would have resulted in a loss.

Pros and Cons of Forex

Pros

The forex was once the exclusive province of banks and other financial institutions. The internet has blasted the doors wide open.

Entry costs are low and the marketplace is open around the clock. There are many choices of forex trading platforms, including some that cater to beginners. There also are online forex trading courses that teach the basics.

Cons

Those financial institutions and the traders who work for them are still there, alongside the neophytes working from home. They have deep pockets, sophisticated software that tracks currency price movements, and teams of analysts to examine the economic factors that make currency rates move.

Currency trading is a fast-moving, volatile arena. It's risky business and can be made riskier by the use of leverage to increase the size of bets.

It's an easy way to lose money fast. Anyone willing to jump into the Forex should get the necessary training in advance, and start slowly with a minimal stake.

Forex Terms

There are a number of terms that are used by Forex traders. Here are some of the basics.

Going long: Buying a currency on the belief that its value will increase in a matter of hours. Then it can be sold for a profit.

Going short: Selling a currency on the belief that its value will decrease. It can then be repurchased at a lower price.

Currency pair: Every Forex transaction is an exchange of one currency for another. A currency pair quote looks like this: USD/GBP = $1.15. In this example, the U.S. dollar is the base currency, and the British pound is the quote currency. A trader who wishes to buy British pounds will pay $1.15 for each.

The ask: The price the trader will pay to buy a currency pair.

The bid: The price the trader will pay to sell a currency pair.

The spread: The difference between the buying price and the selling price.

Major Currency Codes on the Forex

Just seven currency pairs represent the majority of trades on the Forex. They are:

EUR/USD (Euro/U.S. dollar)

USD/JPY (U.S. dollar/Japanese yen)

GBP/USD (British pound/U.S. dollar)

AUD/USD (Australian dollar/U.S. dollar)

USD/CAD (U.S. dollar/Canadian dollar)

USD/CHF (U.S. dollar/Swiss franc)

NZD/USD (New Zealand dollar/U.S. dollar)

The Bottom Line

The forex, or FX, is the global marketplace for the exchange of currencies. As such, it determines the value of one currency against another in the real world.

Forex prices determine the amount of money a traveler gets when exchanging one currency for another. Forex prices also influence global trade, as companies buying or selling across borders must take currency fluctuations into account when determining their costs. Inevitably, the forex has an impact on consumer prices, as global exchange rates increase or lower the prices of imported components.