There are many different types of trading, and foreign exchange trading is both a popular and complicated one. The foreign exchange market is run by a global network of financial institutions and other organizations and is considered de-centralized. For this and other reasons, it is one of the most unique types of market trading.
Forex, a shortened term for foreign exchange, is the process of exchanging one currency for a different currency, such as when you trade Euros for U.S. dollars (USD), or vice versa. This can be for a variety of reasons, but is usually for trading, tourism, or other commerce-related purposes.
Currencies need to be traded in order to conduct foreign trade; any goods and services that cross from one country to another require a currency exchange. Unlike other markets, the forex international market has no central marketplace. Instead, the trading happens electronically over-the-counter (OTC). This means that all transactions take place via computer networks between traders and dealers around the world.
Forex markets are the largest and most liquid asset markets in the world, trading trillions in various currencies every day. They are considered the market closest to perfect competition, although this is largely an ideal rather than an achievable state.
Other terms that are commonly used to refer to the forex market include FX, forex, foreign exchange market, and currency market.
What Is Forex Trading?
In simple terms, forex trading is changing one form of currency into another within an international market. This trading will always involve a currency pair, which means that you’ll always be selling one currency while buying a different one.
The foreign exchange market doesn’t set a currency’s absolute value based on its individual properties. Instead, the market determines a relative value based on how each currency compares to the others. As currencies are traded in pairs, this is both necessary and practical. For example, $1.00 in the US may be worth ₹73 in India.
International banks and larger financial institutions are the main participants in forex trading. These global financial centers serve as trading anchors, setting the market standards and stabilizing currency rates and exchanges. They serve as the middlemen between the various types of buyers and sellers.
Some of the more well-known examples of such international banks include:
- JP Morgan Chase & Co. (American)
- Deutsche Bank AG (German)
- XTX Markets (British)
- UBS Group AG (Swiss)
These four banks are in the top 10 global currency traders and together make up over 30% of the total forex market share.
The foreign exchange market is divided into different levels of access. The levels directly correspond with the financial power and breadth of the participants. This means that the businesses with the most money are at the top and the companies or individuals with the least amount of money (and therefore the least amount of trading power) are in the lower levels. International banks like the ones listed above and similar institutions are the only ones granted access to the highest tier and make up approximately half of all forex transactions.
Forex Transactions Vs. Forex Trading
Though forex trading is essentially exchanging one type of currency for another, not all currency exchange counts as forex trading.
Most individuals have exchanged currencies at one point in their lives, either directly or indirectly. For example, if you’re in the US and go on a weekend trip to Mexico or buy a custom sign from a Russian Etsy shop, you’ll have to convert your USD into pesos or rubles. In the former scenario you’d have to visit a local currency exchange or ATM capable of converting currencies, while in the second you’d just input your preferred payment method and a program would take care of all the necessary financial details.
But this isn’t the same as engaging in forex trading. Forex trading is a deliberate process; individuals can’t accidentally participate in it, and it’s much more complicated than going to a local currency exchange. Converting or exchanging currency is considered a forex transaction, not forex trading.
This is a somewhat confusing but important distinction. The two process are related and fundamentally function in the same manner, but are ultimately different with regard to how people engage in them.
Some of the key differences between converting currency and forex trading include:
- Profits and Losses – When converting currency, the goal is not to make a profit or avoid loss; instead, you simply need to trade out one type of currency for another. In forex trading, the goal is to increase profit margins and decrease losses as much as possible.
- Involved Parties – In forex trading, two parties are involved: either two different institutions or individuals or one institution or individual and the market itself. In conversions, one party is generally involved: the person who needs the money switched to a different currency.
- Contracts – There are no contracts involved when converting currency. Instead, the entity responsible for the transaction simply identifies and uses the present conversion rates. Details like interest rates and settlement dates are not discussed prior to the conversion.
Altogether, forex transactions are a much easier and accessible process than forex trading. Almost everyone has changed currency from one form to another at some point, whereas comparatively few people participate in forex trading.
Components of Forex Trading
There are a lot of terms that come with information about forex trading related to the various aspect of foreign exchange. While some of the terms and what they represent may be obvious, others can be trickier or more confusing. Common components of forex trading and the terms used to refer to them include:
- Markets – Under the umbrella of forex trading are different markets that allow traders or parties to exchange currency in different ways. Each involves its own types of contracts, advantages, and disadvantages.
- Interbank Market – International banks and other financial institutions often utilize a smaller number of financial firms, called “dealers.” These dealers work behind the scenes and are involved in the majority of forex trading. As a result, this network is often referred to as the “interbank market,” although dealers can also be insurance companies, financial firms, etc.
- Currency Pairs – Currency can only be traded in pairs, so most trades are categorized into one of four types of forex pairs, also called currency pairs.
- Pip – Pip stands for percentage in point or price interest point. It is the measurement unit used to show change in a forex pair. All major currencies except for the Japanese yen are priced to four decimal points, and a pip is one unit of the fourth decimal point. So if the USD in a major pair changes from $1.23462 to $1.23472, the USD has moved 1 pip.
Though these terms may be unfamiliar, they are fairly straightforward when broken down to their basic functions and how they are involved in forex trading.
Forex Pairs and Pricing
In addition to having unique symbols, different currencies are represented by three-letter codes. Generally, the first two letters of these codes stands for the country and the third letter refers to the name of the currency itself. For example, USD stands for the U.S. dollar, while JPY stands for the Japanese yen.
Currencies are traded in pairs. There are four types of forex pairs:
- Major Pairs – These are the most frequently traded pairs, comprised of 7 currencies that make up the majority of all trading.
- Minor Pairs – These are the less frequently traded pairs that involve currencies outside of the major 7.
- Exotics Pairs – These pairs involve one major currency and one currency from a smaller or emerging economy.
- Regional Pairs – These pairs are classified by region, such as Scandinavian or Australian.
The pairs are presented together with a dash separating them, such as USD/JPY. The first currency in a forex pair is the base currency, which is being bought. The second currency listed is the quote currency, which is being sold in the trade. The base currency is generally presented as a 1:X conversion ratio. So, USD/JPY would be shown as trading at 1:105, meaning one dollar is worth 105 yen.
Forex Trading Markets and How They Work
Though a few different examples of how to trade currency has been discussed, there are only three official ways to trade forex. Individuals, institutions, and corporations must use at least one of three types of markets in order to engage in this type of trading.
- The Spot Market
- The Forwards Market
- The Futures Market
Each market deals in different types of contracts or deals. Additionally, each market takes place in a different time with regard to when the currency exchange will take place.
The futures market was the most popular market when forex trading first developed and through its early stages. However, the spot market has more recently become the most commonly used as a result of the rise in electronic trading and forex brokers. Because of this, people are usually referring to the spot market when they mention the forex market.
The Spot Market
In this market, currencies are bought and sold according to their current price or value. Finalized deals are called “spot deals” because they happen right then (i.e, on the spot) or within a very short period of time, which is what gives this market its name. These deals are bilateral transactions, meaning that both parties actively take part in the deal and affect its outcome. Both parties must agree on the amounts, types, and exchange rate values of the currencies to be traded. Upon agreement, both parties deliver their currencies to the other, receiving an equivalent amount in return. After a position is closed, the settlement is in cash. Although the spot market is known for dealing in real-time transactions, the trades technically take two days for settlement.
The Forwards and Futures Markets
There are several similarities in the forwards and futures market. This can make it somewhat confusing to differentiate between them, but there is a fundamental difference in how the two markets operate.
The similarities are as follows:
- Both markets don’t deal with actual currencies, but instead with representative contracts that state currency types, values, and an agreed-upon future settlement date.
- Contracts in both markets are binding and usually settled for cash at the exchange upon expiry, although they can be bought or sold before the set expiration date.
- Both markets offer more protection against risk when trading currencies as compared to the spot market. For this reason, larger corporations and businesses prefer these two markets since they can hedge against future exchange rate speculations.
In the forwards market, contracts are bought and sold OTC between two parties. These parties have the freedom to determine the terms of their agreement, such as the specific amount of currency to be exchanged and a settlement date or period.
But in the futures market, only one party takes part in these contracts; the second party is the exchange itself, which sets the terms of the contract. These contracts are bought and sold based on a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. This means that the details of each contract are not customizable. Instead, future contracts automatically have specific details in them, including the number of units to be traded, delivery and settlement dates, and minimum price increments. In some countries, including the US, the futures market is regulated by federal organizations.
When Does Forex Trading Take Place?
The forex market is open 24 hours a day, five and a half days a week. The market is generally closed on weekends, although the global nature of the market and time zones mean that does technically operate on Saturday and Sunday depending on the country. Currencies are traded worldwide across almost every time zone in the following major financial centers:
- New York
- Hong Kong
Even if the trading day is over in New York or London, it will be open in Hong Kong or Tokyo. The forex market is open from 22:00 GMT on Sunday in Sydney, Australia to 22:00 GMT Friday in New York, US. Because of this nearly continuous operation, the forex market is often extremely active at all times of the day and price quotes can change constantly.
What Determines the Value of Currencies?
Currencies and their value fluctuate as often as day to day and are affected by a variety of factors. The final price and value is determined by supply and demand, which reflects factors such as:
- Current Interest Rates – How high or low the current interest rates are can directly determine or affect the value of a country’s currency. More than anything, unstable rates that fluctuate irregularly will negatively affect a currency’s value.
- Economic Performance – How a country’s economy is currently performing, either independently or as compared with other countries, affects the supply and demand of that country’s currency.
- Political Events – Local or global political events can affect the value of currencies, called geopolitical risk; how currency is affected is determined by whether the impacts of the events are positive, negative, or yet to be determined.
- Future Economic Projections – A country’s future economic projections can affect currency more than the present circumstances, especially if future events are expected to have negative impacts on the country.
- Expected Currency Performance – Similar to how a country’s economy is compared to other countries’ and examined independently, currencies and their expected performance (such as inflation) are also examined.
It can be frustrating to compare currencies and their values, especially when they are disparate. It’s tempting to ask why the exchange rate can’t be 1:1 in order to make forex trading and current exchanges simple. However, while it’s true that this would certainly simplify matters, keeping currency static can actually do more harm than good. It’s also unrealistic and would essentially invalidate the value of the currency.
Tips for Engaging in Forex Trading
There’s no singular way to engage in forex trading that will guarantee success or high profit margins. Every trading has its own nuances and risks, and forex trading is no different. However, there are some tips that can help traders and increase their chances of success.
- Research, Research, Research – You can never do too much research when it comes to forex trading. Before you put any money down, make sure you understand foreign exchange markets, the current state of the global economy and currency indicators, and the inherent and potential risks. It’s best to have a plan in place before starting trade, in addition to backup plans in case of losses.
- Keep Emotions Out of It – Money is often a sensitive subject, so it’s no surprise that trading with it (and essentially risking it) can be a highly emotional process. However, it’s essential to remain detached and logical when engaging in forex trading. Emotions have no place in this process and often cause traders to make impulsive or unwise decisions. Make a plan and stick to it, and don’t be afraid to cut your losses.
- Consider Brokers and Dealers – If you feel daunted by the prospect of engaging in forex trading and are unsure about how to approach it, consider hiring outside help in the form of a brokerage company or dealer. This gives individuals a level of trading independence and control with the added advantage of being guided by seasoned traders with inside knowledge.
A prepared individual is more likely to be a successful trader, though people shouldn’t overlook the importance of firsthand experience either. Following the tips above can help traders avoid common mistakes and hopefully reduce their margin for error.
Advantages of Forex Trading
Somewhat obviously, there are definitely advantages to forex trading. Its popular and common not only out of necessity, but also because it can be profitable. Besides this, there are also several other advantages of forex trading.
- Liquidity – As mentioned earlier, forex markets are the largest in the world based on daily trading volume. Because of this, they offer the most liquidity. This means it’s easy to enter and exit positions in any of the major currencies. It’s also fast— you can enter or exit in less than a second for a small spread in most, if not all, market conditions.
- Availability – The forex market is almost always open, 24 hours each day, five and a half days every week. The trading day starts in Sydney, Australia and ends in New York, US. Reference the section “When Does Forex Trading Take Place?” for more information on major financial centers and the market’s availability.
- Leverage – Banks, brokers, and dealers allow a high amount of leverage, which allows you to trade with more money than what you have in your accounts. For example, trading 2:1 with $500 means you can leverage up to $1,000. This can quickly increase your profits and give you access to trades you’d otherwise be priced out of.
Though these advantages are compelling, they are balanced out by the disadvantages and risks that also come with foreign exchange trading.
Disadvantages of Forex Trading
As with any activity, there are both advantages and disadvantages. The disadvantages are generally outweighed by the advantages and there are several mitigation strategies that can minimize them, but they are nonetheless present.
- Leverage – With greater risk comes greater reward— or disaster. With leverage rations as high as 100:1, it’s easy to control large positions with very little money, and just as easy to lose that money if you make a bad deal. Misusing leverage can bankrupt accounts within days and entice traders to gamble with money they don’t actually have.
- Knowledge – Successfully and profitably trading requires a thorough understanding of various countries’ currencies, in addition to each country’s economic fundamentals, value indicators, and inter-country relationships. That is to say, forex trading requires a “big picture” view of the global economy, which can be difficult to accomplish.
- Experience – Forex trading isn’t impossible to grasp or participate in, but it does greatly benefit those who are already experienced, such as insiders or seasoned traders. In fact, 77% of traders on average lose money. This high failure rate can be overcome, but not without adequate research— if you don’t prepare, you will be part of the statistic.
Potential traders and investors shouldn’t be necessarily discouraged by these disadvantages, but they should carefully consider them and proceed with caution. People should also consider the risks in addition to the disadvantages. Though the two are often used synonymously, they are very different and deal with different facets of the industry.
Risks of Forex Trading
Like any other type of trading, there are risks in addition to the benefits of forex trading. These risks vary depending on where the trading parties are located, the trader organizations they use, and more.
- Regulation – The interbank market has varying degrees of regulation but no set standard. Similarly, government oversight and industry regulation varies by country.
- Standardization – Forex instruments are not standardized across the countries or platforms, which creates inherent risk.
- Brokerage – Smaller retailers, businesses, and individuals often use similarly small forex brokers and dealers, who can re-quote prices, trade against their own customers, or otherwise cheat customers when safeguards are lax or nonexistent.
To avoid some of these risks, it’s best for investors to thoroughly research forex dealers and the market in order to understand existing regulations (or lack thereof), available account protections, and advantages and risks. For example, US and UK dealers tend to offer more oversight, but this doesn’t necessarily mean they have the best safeguards against market crises.
This doesn’t mean that there aren’t other aspects of the risks that are positive, however. Using one of the risks described above, although the interbank market isn’t regulated, the sheer size and power of the participating banks means that it’s almost impossible for rogue traders to influence a currency’s value. In turn, this increases market transparency.
Other Uses for The Forex Market
All forex markets deal in contracts or deals that involve exchanging money at certain times for certain rates. However, there are some other, more specific uses for foreign exchange markets:
- Forex for Hedging – The fluctuations in currency previously discussed, while completely normal and healthy, can put companies at risk when they buy or sell goods or services in foreign markets. Inflation and devaluation can put their profit margins and production lines in jeopardy or cause serious disruptions. Forex markets provide a more stable way to hedge these risks by fixing transaction rates. In the forwards and futures markets, companies can buy or sell currencies in advance, locking in exchange rates and ensuring fluctuations won’t impact their business.
- Forex for Speculation – Volatility and change in forex markets as a result of the changing value of currencies can create profitable opportunities. Traders that correctly bet on forecasts about increases or reductions in one currency’s value as compared to another are able to profit.
Global or national financial institutions and other companies are the primary parties that use forex trading for hedging and speculation, since both generally require larger amounts of money. Though individuals may also participate in forex trading for either of these reasons, they are less likely to have a substantial profit margin.
History of Forex Markets
Forex markets are either centuries old or relatively new, depending on how you interpret them. This is another area where the differences between trading currency and forex trading come into play.
- Exchanging Currency – If you’re strictly considering people converting one currency into another for a financial advantage or purpose, then forex markets have existed since nations began creating currencies and trading them with each other.
- Forex Trading – If you’re considering modern forex markets as we encounter them today, then they’re much younger than traditional stock markets.
Following World War II, strict rules and regulations were set on foreign exchange transactions. The exchange rate was fixed and there were severe limitations on commercial and financial interrelations. This type of monetary management was based on the Bretton Woods system, which obligated countries to maintain external exchange rates within 1% by tying global currencies to gold.
It wasn’t until the 1970s that the foreign exchange market as it is today began to form. After the 1971 Bretton Woods accord, currencies were allowed to interact more freely. Fixed exchange rates gradually transitioned to floating exchange rates, which continues to be their present state. As the values of individual currencies changed and became varied, the need arose for foreign exchange services and trading.