Forex, or the foreign exchange market, is the world’s largest financial market. It is the market in which investors from all over the world buy and sell currencies.
In essence, the forex market is a decentralised market, meaning that there is no single physical location where the actual trading, that is the buying and selling of currencies, takes place. Forex transactions are executed directly between the buying and selling parties on an over-the-counter basis, over a vast electronic network of trading platforms. Due to its geographical dispersion in different time zones, the forex market basically operates 24 hours a day, except weekends.
The forex trading market is also unique in that it involves a huge variety of actors. First, there are the national and central banks of every country participating in the forex market for macro-economic purposes, such as controlling inflation. Then, there are commercial companies, including multinational corporations, brokers, currency traders, importers and exporters, as well as hedge funds and investment management companies. The advancement of electronic trading platforms also facilitates the participation of smaller financial firms and self-directed investors. As a result, the forex market is the largest global market in terms of traded volume.
Although the forex market is unique, it is also very similar to other financial markets since it operates on the basis of supply and demand, which in turn presents investors with the opportunity to make profit on the basis of macro-economic factors driving currency values in both directions. In a way, forex trading may be compared to the trading of shares, since forex traders and speculators trade off the back of different currencies and their fluctuating variations in pretty much the same way as a trader might buy and sell shares.
The forex market presents a variety of opportunities for investors, which is the reason for the growing importance of foreign exchange as an asset class. And yet, to make profit out of trading currencies, potential investors need to understand how the forex market works, how it might respond to different economic triggers as well as how to manage the risks associated with forex trading.
There are three categories of forex pairs – majors, minors and crosses. The majors are the most liquid forex pair category, making them the preferred choice of forex traders. A major currency pair consists of one of the major international currencies – GPB (the pound), EUR, JPY (the Japanese yen) or the CHF (the Swiss Franc) – all traded against the USD.
The second forex category includes the minors. A minor currency pair consists of a minor currency such as the Australian dollar (AUD), the Canadian dollar (CAD), the Scandinavian currencies, and so on, again traded against the USD.
Currency pairs in the third category are usually referred to as “crosses” or “cross pairs”. These are forex pairs which do not include the USD as part of the pair.
It will be apparent that the US dollar plays an important role in forex trading. And yet, the popularity of pairs with EUR as one of the currencies has grown considerably since the common European currency was introduced in 1999. As a result, there is an ongoing debate whether forex trading will remain dollar-centred in the future.
Understanding a forex quote
As is the case with financial markets in general, there are two prices quoted for each currency pair – the “bid” price on the left and the “ask” (sometimes also referred to as “offer”) price on the right. The difference between the bid and the ask price is known as the spread, representing the cost of the trade. Most currencies are quoted to four decimal places, the main exception being the JPY, which is quoted to two decimal places.
A forex quote looks like this – GBP/USD 1.7995 – 1.7999. In this example, the difference is four units, or four pips. A pip is the smallest increment of trade and one pip usually equals 1/100 of 1 percent. Currency pairs are generally traded as set unit quantities of the base currency (i.e. 100,000 units), whereas the profit of the trade is calculated in the second currency.
How to trade forex
Example 1 – Going long
You decide to go long on GBP/USD and buy 100k of the GBP/USD currency pair, with the current quote being GBP/USD 1.7995 – 1.7999. The GBP does indeed rise and the following day the GBP/USD quotes 1.8101-1.8105. At this point you decide to close your position and bank your profit, meaning that you sell 100k of GBP/USD. In consequence, the gross profit of your trade equals $1,020, or (1.8101-1.7999)*100,000.
Example 2 – Going short
Alternatively, if you believe that a currency pair is going to fall, you can go short on it, that is, sell it. The EUR/USD currency pair is currently quoted at 1.2435-1.2440, and you open your position by selling 500k at the bid price, that is 1.2435. At some point, the EUR/USD pair falls to 1.2420-1.2425 and you decide to close your position by buying 500k at the offer price (that is, 1.2425) and subsequently earn gross profit of $500.
Understanding how forex trading works might seem a little bit difficult at first. In practice, however, it is rather straightforward; if you go long on a currency pair and the numbers go up, you will make a profit, if it goes down, you will finish at a loss, with the rule being reversed if you go short on a pair – if the number goes down, you will bank a profit, if it goes up, you will have to accept a loss.
In any case, before you invest actual money in forex trading, it is a good idea to open a demo account with a forex trading platform where you can become familiar with the market specifics and test different positions in a safe and stress-free environment. In part 2 of this series we continue the topic by exploring the different risks and benefits associated with forex trading, continue reading here.