Foreign exchange, also known as FX or forex, or currency trading, is the exchange of different global currencies. The changes in currency values reflect supply and demand. Traders aim to profit by buying and selling currencies based on their shifting values. The shifting values of currencies in the market affect the prices of goods and services worldwide.
The largest financial market in the world, forex is a prevalent alternative investment, but many individual investors find it too challenging and risky to participate. Forex has the propensity to generate sizable returns for experienced traders, but it’s also complicated. Here’s what to know:
How Does Forex Trading Work?
Forex operates differently than many other types of investments. The forex market is open for trading 24 hours daily, Monday through Friday. Four main forex trading centers worldwide cover different time zones: London, New York, Sydney, and Tokyo.
Unlike the stock exchange, there is no physical foreign exchange market. Banks and financial institutions run the market rather than central exchanges, and all trading occurs over the counter.
All forex trades occur in currency pairs. For instance, an investor can trade U.S. Dollars for Euros or vice versa. With every transaction, they buy one currency and sell the other.
All currencies continuously increase or decrease in value relative to other currencies. Values shift due to international or national events such as elections, wars, economic crises, natural disasters, etc Bank and federal announcements such as gross domestic product (GDP), inflation reports, employment figures, and quantitative easing measures can affect currency values. Based on what’s happening worldwide, traders predict whether a particular currency will rise or fall about another currency and trade accordingly.
Traders swap currencies in batches or lots. A standard lot is 1000,000 units of currency. Traders can trade mini lots of 10,000 units or micro lots of 1,000 units.
Since traders generally don’t have tens or hundreds of thousands of units of currency to trade, they often use leverage and margin trading to increase their position without having as much capital investment in a trade.
Using leverage can result in greater profits, but there is also a risk of losing more money initially invested. The associated risks are one reason institutional forex investors, rather than individual investors, typically dominate forex trading. For this reason, it’s essential to understand the market, the opportunity cost, and the risks of day trading before using leverage.
Many investors consider forex an alternative investment since it may not correlate to stocks and bonds.
What Are the Major Currency Pairs?
There are four types of pairs in the FX market:
• Major Pairs: Seven currencies comprise 80% of the global forex market. These major pairs include EUR/USD, USD/JPY, GBP/USD, and USD/CHF
• Minor Pairs: Traded less often; many pairs don’t include USD. Minor pairs include EUR/GBP, GBP/JPY, and EUR/CHF
• Exotics: Exotic pairs include one primary currency and one currency from an emerging or smaller market. These include EUR/CZK, USD/PLN, and GBP/MXN
• Regional Pairs: Based on geography, these pairs include, such as AUD/NZD and EUR/NOK
Three Markets to Trade Forex
There are three ways to trade in the forex market, used by both short- and long-term traders.
Spot Forex Market
This involves the physical exchange of currencies. Since it happens physically in real time, traders can complete this transaction on the spot. Traders can buy and sell derivatives based on the spot forex market through over-the-counter exchanges.
Forward Forex Market
In this type of forex trading, traders agree to buy or sell a specific amount of a currency at a set price on a future date.
Futures forex market
In the futures market, contracts for these forward transactions are bought and sold.
How to Read Forex Quotes
Reading and understanding forex pairs can be a bit confusing at first. This is how to read them.
Here’s an example: EUR/USD 1.13012
The currency on the left (EUR) is the base currency. It is always equal to one unit, which in this case would be 1€.
The currency on the right (USD) is called the quote or counter currency.
The number 1.13012 is the value of the quote currency relative to one unit of the base currency. In this example, 1€ = $1.13012. If the base currency (EUR) rises in value, the quote currency number increases since one unit can buy more of the base currency, and vice versa.
Investors buy the base currency when trading forex, in this case, EUR. So, if they want to buy EUR, they buy the EUR/USD pair, and if they want to buy USD, they sell the EUR/USD pair.
Understanding Bid and Ask
Another essential part of reading forex quotes is the bid and ask prices. The bid price is the amount the dealer pays for the base currency, while the asking price is the price they will sell it. Bid prices are always lower than asking prices. The difference between these two prices is known as the spread. A lower spread is better for traders.
Using the example above, the asking price tells a trader how much USD they must spend to purchase one unit of EUR.
The bid price tells them how much USD they will buy when they sell one unit of EUR.
Generally, the bid and ask are shown as the bid/ask. For example, EUR/USD 1.13012/23 would mean the bid price is 1.13012 and the asking price is 1.13023. A trader could sell 1€ for $1.13012 or buy 1€ for $1.13023.
In forex trading, the units that measure the spread, earnings, and losses are called pips, the slightest price movement between pairs of currencies. These are similar to points in the stock market. The value of a pip changes depending on the currency pair, but it generally refers to a movement in the fourth decimal place of a currency pair. Micro pips or pipettes are the decimal places after the fourth decimal place.
The Takeaway
Forex is a popular alternative investment and can be a great way to diversify a portfolio. However, it involves significant understanding and practice and can be risky. If direct forex investing seems daunting, you can still get exposure to forex markets by purchasing ETFs or other funds focusing on foreign currencies.
