Foreign exchange (also known as forex, or fx) is an enormously important aspect of the global financial system. It is a multi-trillion dollar daily market and has implications for all our daily lives.
In this Guide to Forex Trading, we will explain all about what forex is, how the forex market works and the various aspects of forex trading. We will guide you through all the terms you need to know in your preparation for your journey into forex trading.
What is forex?
Let’s start with the basics. Forex is the price that is paid for one currency in exchange for another currency. Forex prices are therefore quoted in pairs of currencies.
What is a forex pair?
There are always two sides to a forex price. As such forex prices are always quoted in pairs. When you buy one currency, you will always be selling another, which is its counterpart via a forex pair.
EUR/USD is the most popular traded forex pair in the world. There are two sides to the pair, the euro versus the US dollar. The euro (EUR) is the “base currency” (which is first) and the US dollar (USD) is known as the “quote currency” or “counter currency” (which is second).
The pair means how may of the quote currency will it take to exchange for a single unit of the base currency. In this instance, how many USD would it take to buy 1 EUR or to sell 1 EUR.
Majors, Crosses and Exotics
We will now look into the currency pairs that are traded. According to the United Nations, there are 180 current currencies across the world. As many as 22 currencies take the name of “dollar”, including the Australian dollar, the Hong Kong dollar, the Singapore dollar and of course the US dollar.
Crossing these currencies together will make forex pairs. Pairs are grouped into three categories:
Major pairs – these are the eight traditionally most commonly traded currencies which includes USD, EUR, JPY, GBP, AUD, CAD, CHF and NZD. All of the major pairs are quoted against the USD. Subsequently, there are 7 major pairs (although some brokers will also regard NOK and SEK as major currencies).
Crosses (or Minors) – these are the crosses of the major currencies that do not include USD. Popular crosses include pairs such as EUR/JPY, EUR/GBP and EUR/CHF.
Exotics – these are forex pairs that are made up of less widely traded currencies, most of which are paired with the USD. Examples are USD/TRY, USD/MXN and USD/HKD.
As we can see in the table below, according to the Bank of International Settlements, currencies such as the Chinese yuan (CNY) and the Hong Kong dollar (HKD) have become increasingly popular in recent years. They are now widely traded and rival some of the major currencies in their volume levels. It is also interesting to see that USD/JPY is the only forex pair in the top 20 to have seen its trading volume decline over the 2019 triennial survey period.
According to the Bank of International Settlements, here is a table of the daily volumes of the top 20 most popular traded currency pairs and the change between 2016 and 2019.
| Forex pair |
2016
|
2019
| Change in Proportion | ||
|---|---|---|---|---|---|
| All currency pairs | $5,066bn | $6,590bn | +30.0% | ||
| EUR/USD | $1,172bn | 23.1% | $1,584bn | 24.0% | +0.9% |
| USD/JPY | $901bn | 17.8% | $871bn | 13.2% | -4.6% |
| GBP/USD | $470bn | 9.3% | $630bn | 9.6% | +0.3% |
| AUD/USD | $262bn | 5.2% | $358bn | 5.4% | +0.2% |
| USD/CAD | $218bn | 4.3% | $287bn | 4.4% | +0.1% |
| USD/CHF | $180bn | 3.6% | $228bn | 3.5% | -0.1% |
| NZD/USD | $78bn | 1.5% | $107bn | 1.6% | +0.1% |
| Total Majors | $3,281bn | 64.8% | $4,065bn | 61.7% | -3.1% |
| USD/CNY | $192 | 3.8% | $269bn | 4.1% | +0.3% |
| USD/HKD | $77bn | 1.5% | $233bn | 3.3% | +1.8% |
| EUR/GBP | $100bn | 2.0% | $131bn | 2.0% | 0 |
| USD/KRW | $78bn | 1.5% | $125bn | 1.9% | +1.4% |
| EUR/JPY | $79bn | 1.6% | $114bn | 1.7% | +0.1% |
| USD/INR | $56bn | 1.1% | $110bn | 1.7% | +0.6% |
| USD/SGD | $81bn | 1.6% | $110bn | 1.7% | +0.1% |
| USD/MXN | $90bn | 1.8% | $105bn | 1.6% | -0.2% |
| USD/SEK | $66bn | 1.3% | $86bn | 1.3% | 0 |
| USD/NOK | $48bn | 0.9% | $73bn | 1.1% | +0.2% |
| EUR/CHF | $44bn | 0.9% | $73bn | 1.1% | +0.2% |
| USD/BRL | $45bn | 0.9% | $66bn | 1.0% | +0.1% |
| USD/RUB | $53bn | 1.1% | $63bn | 1.0% | -0.1% |
Source: Bank of International Settlements Triennial Central Bank Survey 2019
The Forex market
The forex market is the largest market in the world and by a considerable margin. According to the 2019 Triennial Central Bank Survey of forex turnover from the Bank of International Settlements, trading in the forex market had a total daily global turnover of $6.6 trillion. This was an increase from $5.1 trillion just three years earlier (according to data taken from the previous triennial survey in2016).
To give you an idea of the sheer size of the forex market, we can compare it to the size of the global equities market. According to the World Bank, in 2019 the global daily trading volume for equities was around $240bn. In other words, the forex market is over 27 times larger than the equities market.
Forex Markets – Who are the players?
The forex market is truly global. It is effectively an over-the-counter, decentralised market. There are no exchanges like the New York Stock Exchange or the London Stock Exchange which handle your trading. When you trade forex, you can trade it with anyone in the entire world.
The forex market is comprised of central banks, corporate banks, non-financial companies and individuals. Many forex transactions are done for practical purposes, such as importing a piece of machinery. Companies also use forex to hedge their exposure to foreign currency swings. However, much of the forex trading around the world is undertaken by traders (both institutional and individual) to make a profit.
Here are the main players in the forex market:
Central banks – are an incredibly important aspect of the forex market. Primarily, central banks will set the level of interest rates that are crucial to determining the valuation of a currency. Interest rate differentials between currencies are key to the movement in forex. However, central banks can also intervene in forex markets by either buying or selling currencies which can also impact valuations.
Investment and commercial banks – the interbank market (banks trading currencies between themselves) generate the greatest volume of forex trading in the market. Banks will trade on behalf of clients or for themselves through their proprietary trading desks.
Money managers and hedge funds – Any financial organisation running a portfolio will need to consider trading forex. When pension and life insurance funds, asset managers and hedge funds trade international portfolios they will be required to use forex to fund purchases and hedge their portfolios.
Non-financial companies – companies that buy and sell goods from abroad will need to use the forex market. Instruments such as currency swaps will often be used to hedge the risk of currency exposure.
Individuals – retail traders speculating on currency movements through forex brokers.Here is the proportion of daily forex trading per counterparty, as measured by the Bank of International Settlements.
| Forex Counterparties | Total (US$) | Percentage |
|---|---|---|
| Reporting Dealers | $2,522bn | 38.2% |
| Other financial institutions | $3,595bn | 54.5% |
| Non-financial customers | $474bn | 7.2% |
| Spot | ($159bn) | (2.4%) |
| Derivatives | ($315bn) | (4.8%) |
| Total | $6,590bn | 100% |
Source: Bank of International Settlements Triennial Central Bank Survey 2019
A few forex statistics
Here are a few statistics on forex that you might find interesting:
US dollar (USD) is still king – the USD is a massive part of the forex market, being on one side of 88% of forex trades. The euro (EUR) is the second most traded at 32%, with Japanese yen (JPY) third at 17% and the British pound (GBP) fourth at 13%.
EUR/USD is the most traded pair at 24% of total volume – This is followed by USD/JPY at 13.2% and then GBP/USD at 9.6%.
Individual forex trading (both retail and professional) is still a small fish in a big pond – The importance of retail forex (non-financial customers) trading remains relatively small at just 7% of total global market turnover.Here are the top 20 most traded currencies on one side of a forex trade
| Currency | Code | Daily Volume | Proportion |
|---|---|---|---|
| MAJOR CURRENCIES | |||
| US dollar | USD | $5,819bn | 88.3% |
| Euro | EUR | $2,129bn | 32.3% |
| Japanese yen | JPY | $1,108bn | 16.8% |
| British pound | GBP | $844bn | 12.8% |
| Australian dollar | AUD | $445bn | 6.8% |
| Canadian dollar | CAD | $332bn | 5.0% |
| Swiss franc | CHF | $327bn | 4.9% |
| New Zealand dollar | NZD | $136bn | 2.1% |
| OTHERS | |||
| Chinese yuan | CNY | $284bn | 4.3% |
| Hong Kong dollar | HKD | $233bn | 3.5% |
| Swedish krona | SEK | $134bn | 2.0% |
| Korean won | KRW | $131bn | 2.0% |
| Singapore dollar | SGD | $119bn | 1.8% |
| Norwegian krone | NOK | $119bn | 1.8% |
| Mexican peso | MXN | $114bn | 1.7% |
| Indian rupee | INR | $113bn | 1.7% |
| Russian ruble | RUB | $72bn | 1.1% |
| South African rand | ZAR | $72bn | 1.1% |
| Turkish lira | TRY | $71bn | 1.1% |
| Brazilian real | BRL | $71bn | 1.1% |
| Total | $6,590bn | 100,00% | |
Source: Bank of International Settlements Triennial Central Bank Survey 2019
Forex – a 24 hours per day market, 5 days per week
The forex market is a truly global market and forex never sleeps (apart from at the weekends when we all need a good rest). It is a 24 hours a day, five days per week market.
The main trading hubs are London, New York, Sydney and Tokyo. So, no matter what time of day, wherever you are in the world, forex markets are trading. If you are living in Europe the forex market opens late on Sunday evening (from 2100GMT when markets in Asia and Australasia open) and remains open until Friday evening (around 1900GMT when the US session finishes).
However, considering the time zones of Australia and Japan are relatively close together, they are considered to come under just one session. It also means that the Asian session is effectively longer than the others. Markets open as traders in New Zealand take to their desks in the morning, three hours ahead of Tokyo, whilst traders in China and India are also still in bed.
This all gives rise to the 3 session system of forex trading. Here are the times for the various global sessions:
| Session | Main hub | Duration of Session |
|---|---|---|
| European session | London | 0700GMT / 1600GMT |
| North American session | New York | 1200GMT / 2100GMT |
| Asian session | Sydney / Tokyo | 2100GMT / 0800GMT |
Watching the volatility during the session overlaps
Looking at the times that the three sessions are operating, we can see some overlaps. With many more traders active in forex markets during these overlaps, they can be characterised by elevated volumes and subsequently possibly elevated volatility.
As the Asian session is coming to an end and the European session takes hold. There is an overlap of around 1 hour between 0700GMT/0800GMT.
Moving into the European afternoon, US traders are just getting to their desks with their morning coffee. This leaves around 4 hours between 1200GMT and 1600GMT where US and European traders are all active at the same time.
There is also a window of light volume to be aware of. As the US session winds down around 2000GMT/2100GMT it takes a few hours for Asian traders to get stuck into the session. There is a five hour time difference between the west coast of North America and New Zealand, and that is before Tokyo gets going too.
Below we see a volume chart of EUR/USD (the most widely traded forex pair) across 24 hours. We can see the spikes in volume around the session overlaps, but also the lull in volume as the US session hands over to Asia.
We can also see from this that the big volume in forex trading comes during the European afternoon, for the overlap between the European and North American sessions.
Forex speculation
We will now take you through all you need to know about speculation in the forex market, in other words, forex trading.
A simple forex trade
If a trader buys EUR/USD when it was trading at $1.2000, it would cost them $1.20 to buy €1. If the price moves higher to $1.2500 and the trader decided to sell (i.e. close) that position then selling that €1 would generate $1.25. The round trip of the trade has generated a profit of $0.05.
Speculators trade forex on the expectations that forex prices will either rise or fall. You can buy (go long) or sell (go short) of a currency pair.
If you believe that the EUR will strengthen in value relative to the USD you would buy (or go long) EUR/USD. If you believed that the EUR would weaken relative to the USD, then you would look to sell (or go short) EUR/USD.
A forex quote
Here is a real quote for EUR/USD taken from the MetaTrader 4 trading platform.
Here it costs $1.18196 to buy €1 (or 1.18196 US dollars to buy 1 euro). However, you will also note that two prices make up a quote.
What is the spread?
The two prices that make up a forex quote are the “bid price” (here this is the price you buy euros at) and the “offer price” (the price you sell euros at).
- The bid price is always the higher price, in this instance 1.18196.
- The offer price is always the lower price, here 1.18185. This is also sometimes referred to as the “ask” price.
The difference between the Bid and Offer prices is known as the “spread”. This is where forex brokers/dealers make their money. On this quote, the spread is 0.00011 or 1.1 pips. But what does that mean?
What is a pip?
Forex quotes are measured in pips. A pip is a “percentage in point”. In the vast majority of forex quotes, a pip is a single-digit movement in the 4th decimal place of a currency pair.
If the price of EUR/USD moves from $1.1853 to $1.1857 then the pair has moved higher by 4 pips.
Many forex brokers will quote their prices to one-tenth of a pip, adding a fifth decimal place to the price. This is because they have variable spreads in their quotes. For example, the price of EUR/USD may move from $1.18376 to $1.18293. This would be a fall of 8.3 pips.
However, there is a big exception to this rule, and that comes when you are trading the Japanese yen. When you are trading yen crosses, 1 pip is a change in the second decimal place. For example, trading USD/JPY the price moves from 110.52 to 110.57 would be an increase of 5 pips.
The use of leverage
Compared to other markets you can trade, forex pairs do not tend to move that much. It is not uncommon for cryptocurrencies or stocks to move higher or lower by 10% in a day. However, if a forex pair moves more than 1% or 2% in a day it is considered to be a big move. If EUR/USD moved 10% in one day, it would probably mean that the world as we know it was coming to an end and cause absolute pandemonium across financial markets.
So if forex pairs don’t move much, how can you make decent money by trading them? The answer is through leverage.
Lots
On a standard trading account, forex trading positions are measured in “Lots”, where 1 Lot is equal to 100,000 units of the base currency.
If you bought 1 Lot of EUR/USD at $1.1850 then you are effectively trading with $118,500. This would mean that a 1 pip move (remember, the fourth decimal place in the price) would equate to a $10 change in the position.
Therefore on your 1 Lot of EUR/USD that you bought at $1.1850, if the price increased by 22 pips for you to close the position at $1.1872, the total position would now be worth $118,720. The profit on the trade would be $220.
Margin & Leverage
Without leverage, most forex traders would not have the capital available to be able to trade 100,000 units of a base currency. Trading on leverage enables much greater exposure in trade sizes. The amount of leverage available to traders can depend upon the regulatory jurisdiction in which they are trading, however, leverage can be available from thirty times (in European jurisdictions) up to as high as many hundreds of times (with Mauritius, Vanuatu or Bahamas jurisdiction).
For leverage of 30 times, this means that a trader will need to have 3.33% margin on account. For a $100,000 position, a trader would need just $3,300 deposited on the forex trading account.
The risk of trading forex on margin
However, trading in a larger size comes with a much higher risk. As we laid out earlier, trading 1 Lot (100,000 units of the base currency) means that every 1 pip of movement in EUR/USD is worth $10.
Although forex pairs may not move much in percentage terms, when using leverage, a 40/50 pip swing in the price can take a matter of minutes. Unless you trade forex using adequate protection for your positions (such as stop-losses) you can very quickly blow up your account!
Different forms of forex trading
There are several ways in which to trade in forex. You can trade forex spot (buying and selling the underlying currency), or derivatives (using contracts speculate on currency moves). There are several elements to these which we will now explain.
Spot forex – Spot trading is the primary market for forex trading. The participants will tend to be the big banks and this is where we get the term “interbank market” from. Institutional traders will trade between themselves to take delivery between two counterparties using a T+2 delivery (i.e. Today + 2 days).Individual traders (the retail trader) will enter the forex market by using a broker, effectively via a secondary market. The broker acts as an intermediary between the individual trader and counterparties such as big banks. The bigger players will provide the brokers with the liquidity for their clients (individual traders) to use. Brokers offer individuals the ability to trade on margin where traders can leverage their account to many times their original size. However, the warning is that trading on margin significantly increases the level of risk for the trader.
Forex Forwards and Futures – Forwards are private contracts between two counterparties to exchange a currency at a future date at a pre-determined price. Futures are standard contracts to take delivery of a currency at a future date and pre-determined price.The big difference between the two is that forwards are off-exchange agreements, whereas futures are traded on public commodities markets.
Forex Options – Trading forex options gives you the right, but not obligation to buy and sell forex on a specific date in the future at a specified price. Options trading in forex are similar to futures trading, however, where futures contracts have the obligation for delivery, there is no such obligation when trading options.
Forex Swaps – Swaps are agreements to exchange interest payments between two foreign parties at fixed dates throughout the life of the contract. Currency swaps are used as a long term tool to hedge the currency risk of long term foreign investments. Companies can use swaps to gain more favourable loan rates in a foreign currency than they would get from borrowing money abroad.This table lays out the level and proportion of daily volumes of the various forex trading instruments.
| FX Instruments | Total (US$) | Percentage |
|---|---|---|
| Spot | $1,987bn | 30.2% |
| Derivatives | $4,603bn | 69.8% |
| Outright forwards | ($999bn) | (15.1%) |
| FX Swaps | ($3,202bn) | (48.6%) |
| Currency Swaps | ($108bn) | (1.6%) |
| FX Options | ($294bn) | (4.5%) |
| Total market | $6,590bn | 100,00% |
Source: Bank of International Settlements Triennial Central Bank Survey 2019
How to be a forex trader?
Now let’s take you through a few steps of how to become a forex trader:
Learn your trade – Read around the subject of trading forex. It is always best to understand what you are getting into. Before you take the plunge into forex trading is good to know all about spreads, leverage, volatility, and why forex markets move. This will help to give you a base from which to develop your skills.
Set up an account with a forex broker – do your research into which broker fits your priorities. Some will be good on fees, some will help you with trading ideas, some good for customer service. Think about what is important for you. Websites such as BestBrokers.com can help.
Develop a trading strategy – trading with a scattergun approach is not going to be profitable for you in the long run. Spend time thinking about how you generate trading ideas, how you will manage your positions and exit strategies. This will give you the biggest opportunity for success. Oh, and learn all about how to use the trading platform too. This will help you from making costly elementary mistakes.
Self-reflection – going into forex trading with your eyes shut is the quickest way to losing your money. Trading is an emotional rollercoaster. If you can understand why you make decisions, then you can learn from your mistakes and hopefully correct them.
Stay on top of current events – Markets are constantly changing direction. Know your markets, and know what makes them tick. Keeping on top of current market-moving events will allow you to alter your positioning as markets swing around.What is a forex broker?
It is possible to take your dollars or your euros to the local foreign exchange bureau to buy and sell other currencies. Although this is a form of forex trading, you will get a terrible rate of exchange and you will find your funds will quickly diminish as a result.
Fortunately, there is an easier way for individuals to enter the forex market and have the opportunity of making a profit. However, they need a little assistance. Traders would need an intermediary to link them to the market. This intermediary is a foreign exchange trading provider, also called a forex broker.
A broker will provide a trader with a trading platform and access to the forex market. The trader can then speculate on the movements in forex markets. The broker can also provide the trader with leverage for their account, giving greater levels of exposure and the ability to make greater profits. The broker executes the trades for the trader, in exchange for a fee (either generated through the spread or commission).
Different Styles of Forex trading
There are many different ways in which traders dip their toes into the forex market. Some traders look to trade with an extremely short term outlook, whilst some like to play the long game.
Let’s take a look at the various methods you could employ
| Trading style | How often do you trade | Length of time holding a position | Idea generation |
|---|---|---|---|
| Scalping | Many per day – Positions opened and closed very quickly | A few seconds to minutes | Short term Technical Analysis |
| Day trading | Several per day | Several minutes to hours | Data / Newsflow / Technical Analysis |
| Swing trading | Several per week | A few days | Technical Analysis |
| Trend chasing | Several per month | A few weeks | Technical analysis |
| Position trading | A few per year | Months, maybe years | Fundamentals |
What moves forex markets?
Forex markets move around on a multitude of factors. The outlook for one currency relative to another is a crucial aspect of how forex moves. Factors that change this outlook and predicting these moves can be the difference between success and failure.
Here are some of the main factors that move markets:
The outlook for interest rates – to prevent an economy from either overheating or undercooking, central banks will change the level of interest rates to manage the economy. Forex markets move on the speculation of the next move that central banks will take or the long term path of interest rates in the future. Bond yields are the primary reflection of this and, with this, forex rates will react according to bond markets.Newsflow – newsflow on political events (such as changes of government), economics data (such as inflation, growth or unemployment) and naturally occurring events (such as natural disasters) can all impact the price of a currency and its relative valuation measured against other currencies.
Sentiment – market forces, momentum and sentiment are all important aspects of how forex moves. Traders use analytical tools such as fundamental analysis and technical analysis to predict how markets will move.Pros and Cons of forex trading
Before you start trading forex, there are a few factors you might want to weigh in your mind. There are many reasons why forex trading is so popular with the retail market. However, trading forex does also come with its risks too.
Here are a few pros and cons of forex trading:
Key Pros
- Trade forex 24 hours per day, five days a week – markets are open every hour, Monday to Friday. This allows traders to trade markets when they want, day or night.
- Go long or short – when trading forex, you can speculate on the price moving higher or lower. Whichever way you think the market direction is headed, you can profit. It’s your call.
- Lower fees – Trading in equities, bonds and funds (such as ETFs and mutual funds) will often incur extra fees and commissions, possibly even on top of the spreads charged. If you do your research and pick the right broker, trading forex can be an asset class that keeps your trading costs much lower than other assets. Commissions and extra fees are not typically a feature of trading forex (unless you choose a zero spread account that specifically does this to reduce costs even further).
- Forex markets are highly liquid – the huge number of market participants enable tight spreads and reduced gapping. Tight spreads on markets help to keep the costs of trading low. With forex, you are trading in a truly global market, meaning that with so many participants this reduces the potential for slippage and gaps when orders are being filled.
- Trade forex on margin – gives you the exposure to make bigger profits. Brokers will tend to offer higher margin levels on forex instruments. With the high levels of liquidity and fast moving markets, trading forex on margin enables traders to make faster returns.
Key Cons
- Margin trading can be a negative as well as being a positive. Margin trading in combination with highly volatile markets means that forex trading can be very high risk.
- Overnight financing charges – arguably the hidden costs of forex trading. Traders are often (but not always) charged just for holding positions open overnight. This is in contrast to investing in equities or bonds which have no financing charges and periodically pay a yield (either dividends or interest) for holding the asset.
- The disadvantage of being a small fish in a big pond – forex markets are dominated by the big banks who have access to state of the art technology, research and can influence prices with their positions. Forex retail traders can feel like they are being buffeted around by the bigger players in the game. However, just because the banks are bigger, it does not mean they are always right.
Conclusion
Forex trading is an extremely popular form of investment. Due to the availability of margin, successful forex traders can achieve anything from a nice profitable pastime to making a lucrative living.
In this guide, we have explained what forex is, explained how the forex market works and described how to start the journey into forex trading. As we have also tried to explain, the most important aspect to remember is to do your research and go into it with your eyes wide open.
Good luck with your forex trading everyone!
