What is Forex trading?
Forex or foreign exchange can be defined as a network of buyers and sellers who exchange currencies between themselves at an agreed upon price. This is how individuals, companies and central banks convert one currency into another - if you've ever traveled abroad, you've probably made a Forex transaction.
While much foreign currency is converted for practical purposes, the vast majority of currency conversions are done for the purpose of making profits. The amount of currencies that are transferred daily can lead to significant fluctuation in the price movement of some currencies. This volatility is what makes the Forex market attractive to traders: it brings great opportunities to make great profits, and also involves increased risks.
Explore a host of other benefits of Forex trading
How do currency markets work?
Unlike stocks or commodities, Forex is not traded on exchanges, but rather directly between two parties in the over-the-counter (OTC) market. The Forex market is managed through a global network of banks distributed among four main Forex trading centers in different time zones: London, New York, Sydney and Tokyo. Since there is no central location, it is possible to trade Forex 24 hours a day.
There are three different types of Forex markets:
Spot Forex market: The physical exchange of a currency pair, which occurs at the specified point for settlement of the trade - that is, immediately - or within a short period of time.
Forward Forex Market: In which a contract is agreed to buy or sell a specific amount of currency at a specific price, to be settled on a specific date in the future or within a set of future dates.
Forex futures market: in which a contract is agreed to buy or sell a specific amount of a specific currency at a specific price and a specific date in the future. Unlike futures contracts, futures contracts are legally binding
Most traders who speculate on Forex prices do not plan to take delivery of the currency itself, instead they make exchange rate predictions in order to take advantage of price movements in the market.
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What is the base currency?
The base currency is the first currency in a Forex pair, while the second currency is called the quote currency. Forex trading always involves selling one currency in order to buy another, which is why it is listed in pairs – the price of a forex pair is the value of one unit of the base currency in the quote currency.
Each currency in the pair is listed as a three-letter code, with the first two letters usually standing for the region, and the third for the currency itself. For example, GBP/USD is a currency pair that involves buying the British pound and selling the US dollar.
Base currency and quote currency
To maintain order, most providers divide pairs into the following categories:
Major pairs. Seven currencies make up 80% of global Forex trading. They include: EUR/USD, USD/JPY, GBP/USD and USD/CHF
Secondary pairs. It is less traded, and it benefits from trading major currencies against each other instead of the US dollar. They include: EUR/GBP, EUR/CHF and GBP/JPY
Non-major or uncommon pairs. A major currency against one from a small or emerging economy. They include: USD/PLN, GBP/MXN, EUR/CZK
Regional or regional pairs. Pairs sorted by region - such as Scandinavia or Australia. They include: EUR/NOK, AUD/NZD and AUS/SGD
What moves the Forex markets?
The Forex market consists of currencies from all over the world, which makes it difficult to predict exchange rates as there are many factors that may contribute to price movements. However, like most financial markets, Forex is primarily affected by the strength of supply and the strength of demand, and it is important here to understand the influences that lead to price fluctuations.
Central banks
Supply is controlled by central banks, which can announce measures that will significantly affect the price of their currency. Quantitative easing, for example, involves pumping more money into the economy, and may cause the price of its currency to fall.
News reports
Commercial banks as well as other investors tend to place their capital in economies with strong prospects. Therefore, if positive news about a particular region occurs in the markets, this will encourage investment and increase demand for that region's currency.
Unless there is a parallel increase in the supply of a currency, the discrepancy between supply and demand will cause its price to rise. Likewise, negative news can cause a decline in investment and reduce the price of a currency. For this reason, currencies tend to reflect a vision of the health of the economy of the region they represent.
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Market sentiment
Also market sentiment, which is often a reaction to news, may play a major role in increasing currency prices. If traders believe a currency is trending in a certain direction, they will trade accordingly and may convince others to follow the same, causing demand to increase or decrease.
How does forex trading work?
There are a variety of different ways you can trade Forex, but they all work the same way by buying one currency and selling another at the same time. Traditionally, many forex transactions were conducted through a forex broker, but with the rise of online trading you can profit from forex price movements using derivatives such as CFD trading.
CFDs are leveraged products that enable you to open a position for a fraction of the total value of the trade. Unlike non-leverage products, you do not take ownership of the asset, but rather a position depending on what you expect will rise or fall in the market value.
Although leveraged products may multiply your profits, they may also multiply your losses if the market moves against you.
Learn more about how to trade Forex
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