What is forex, exactly? Forex is the world's largest and most liquid market, with daily trading volumes reaching over $5 trillion. From the largest sovereign wealth funds to commercial banks and hedge funds to prime brokers and retail traders, forex is open to all for business 24 hours a day and Monday through Friday.
This article will thoroughly answer the question, "What is forex trading, and how does forex trading work?"
What is Forex?
What is forex trading and how does it work? In short, the forex meaning stands for "foreign exchange." Every nation operates on some form of currency. The U.S. has dollars, Europe has the euro, Japan has the yen and South Korea has the won. The U.K. uses the pound note. Whenever a transaction happens between parties in different countries, one country's currency must convert to the other's (and vice versa) to complete the transaction. The conversion is priced based on the current pairs pricing. The FX market determines the exchange rate or daily value of the world's currencies.
When the U.S. dollar is strong, imports to the U.S. get cheaper, but exports from the U.S. get more expensive for foreign buyers. A strong dollar results in a falling stock market as margins tighten due to the currency translation or FX. The strong U.S. dollar has been a headwind for several years, and U.S. companies are posting "constant currency" earnings per share (EPS) to remind investors what the company would have earned if there wasn't an FX impact. A strong dollar is good for U.S. citizens going on vacation overseas as their money has more buying power.
The strong dollar is good for companies buying and importing products or supplies from overseas to sell in the U.S. For example, Walmart Inc. (NASDAQ: WMT) is the largest importer in the U.S. They can import products cheaper into the U.S. and sell in dollars. However, Walmart operates in more than 20 countries, with nearly 17% of its revenues from overseas. Unfortunately, they take a hit on their overseas stores when converting back into dollars for quarterly earnings reports.
Also, foreign companies that sell or do business in the U.S. benefit since they get products made cheaper in their currency to sell for dollars in the U.S., which expands their profit margins.
How Does Forex Work?
Let's delve into how forex trading works and what is traded on the forex. Forex is unlike the stock markets, which operate through exchanges like the NYSE and NASDAQ. It operates electronically between counterparties on a decentralized and over-the-counter (OTC) basis.
The large financial institutions and banks trade with each other on the interbank market serving as market makers providing bids and ask. Hedge funds, prime brokers and institutional traders actively participate in the forex market. Forex brokers connect retail traders to the forex, including the interbank market. They facilitate trades for the retail trader and collect their fees from the spread.
Forex brokers may have slightly different prices from each other due to individual broker spreads or commissions baked into the prices. The forex market is open around the clock as different regions open up for active trading when others close based on the time zones operating during business hours.
Forex used to be a realm exclusive to large banks and financial institutions. In the recent millennium, retail traders knew forex trading's meaning. With the advent of the internet, it has become accessible to retail traders through forex brokers. There are countless retail traders in the forex market due to low barriers to entry. Unlike trading the U.S. stock market, which requires at least $25,000 minimum capital under its pattern day trader (PDT) rules, forex accounts usually have a smaller minimum, from $50 up to $5,000, depending on the broker, which has enticed many retail traders to try their hand at the forex markets. It has also led many traditional brokers to offer forex trading as an option for their customers.
How Does Leverage Work on a Forex Trade?
Leverage is a double-edged sword that can help you score large profits, but it can also blow up your account without discipline and a trading plan. Leverage involves borrowing a larger amount of money to invest with a smaller amount as collateral. Margin builds leverage. Just like in stock trading accounts that use margin, forex accounts use margin at a much higher ratio. Leverage should be considered a tool like your trading platform and charts. Every forex trader must respect the power of leverage.
Leverage enables you to trade larger amounts of money with a much smaller investment utilizing margin borrowing. Like the stock market, leverage is expressed as a ratio of how much you can trade and how much you invest.
A 100:1 ratio means you can control $100,000 currency for $1,000. While the starting minimum balances for a forex account are low, the leverage or margin used to place trades is very high. With margins as high as 100-to-1, you can lose everything and even more on minimal price moves. Remember, you don't just lose what you put into forex. You can lose much more than you put in because of leverage on trades.
Currencies move much smaller and slower than stocks. The price fluctuations are usually microscopic in 1/10,000th of a penny increments, so the leverage must be high to make any sizeable profit for traders. The denominations break down into percentages in points or price interest point (pip). Pips are the smallest denomination or unit that a currency trades in.
Currency quotes usually have four decimal places. For example, a price move from 1.2655 to 1.2659 is a four-pip move. In terms of dollars, a standard lot equates to 100,000 units of base currency, or $10 per pip move. A mini lot is 10,000 of base currency, or $1 per pip move. A micro lot is 1,000 units of base currency, or 10-cent per pip move.
Currency Pairs Overview
Currencies are quoted in pairs or together as the exchange rate. Each currency has a three-letter country code, and each pair has two currency codes. When buying one currency, you are simultaneously selling another and vice versa. The base currency is listed first, and the quote currency is called the counter currency.
If you buy euros, then the U.S. dollar is sold in the EUR/USD pair. For example, the EUR/USD at 1.18 means one euro equals $1.18. The U.S. dollar (USD) is the standard, default and dominant reserve currency unit.
While there are hundreds of currency pairs, the most widely used and liquid are called the majors. Majors are like the blue chips of currencies markets. Major pairs include the U.S. dollar. The four major pairs are:
- Euro and U.S. dollar (EUR/USD)
- U.S. dollar and Japanese yen (USD/JPY)
- British pound sterling and the U.S. dollar (GBP/USD)
- U.S. dollar and Swiss franc (USD/CHF)
The last three are also called commodity pairs, and they include the following:
- Australian dollar and U.S. dollar (AUD/USD)
- U.S. dollar and Canadian dollar (USD/CSD)
- New Zealand dollar and the U.S. dollar (NZD/USD)
These are the most common currencies and ones to get familiar with in your forex trading journey. In case you wondered, the FX market doesn't pay out quarterly dividends like dividend stocks do in the stock market. As you get more acclimated, you may seek out more exotic currency pairs, but be aware that less liquidity means paying more for positions and getting less on exits due to the wider bid and offer spreads.
How to Determine the Right Currencies to Trade
First, understand what factors to consider to determine the right currencies to trade. If you are a beginner, then stick with the major currency pairs. Factors to consider include liquidity, volatility, trading times and trading strategy. The majors tend to fit with all the factors mentioned above. If you're a seasoned trader seeking more action, you can look for exotic pairs to trade. These can have more volatility but come with the risk of wider spreads and thinner liquidity. With thin liquidity, you can be right on the trade but wrong on the execution.
It also helps to have some knowledge of the currency you select. Currencies are sensitive to the underlying country's financials like GDP, inflation, monetary policy, politics, employment data and government economic reports. Be aware of the trading times for your currencies and when it's most active. If you're an evening or early morning person, the USD/JPY or the AUD/USD may work better for you than the GBP/USD.
Types of Forex Trades
Three types of forex trades occur through three different and distinct markets: the spot, forward and futures. Trading on these markets promotes an effective risk management strategy known as currency hedging.
Corporations use forex trading to help protect their costs on products and services sold overseas. In the case of a forward or futures contract, you can lock in some of the rates for a year in advance to avoid the risk of currency fluctuations.
Let's take a look at each of these markets:
- Spot market: This is where currencies are bought and sold based on their current price for immediate delivery (although trades usually settle within two business days). In a spot deal, one party delivers an agreed-upon amount of one currency and receives a specified amount of a different currency at an agreed-upon exchange rate value. Positions are closed in cash. Like all assets, currency prices on the spot market are determined by supply and demand. In the case of forex trading, supply and demand are influenced by factors such as current interest rates, a country's economic performance, investor sentiment regarding political and governmental stability, and investor perception of how one currency will perform against another.
- Forward market: This is where currency contracts are bought and sold OTC between a buyer and seller who set the terms for the contract between themselves. A futures contract is binding for both parties. The distinction between a forward contract and spot deal is that the forward contract is set for a set point in the future, unlike the spot market, based on immediate delivery. A forward contract allows traders to lock in currency prices, particularly when they're anticipating one of the currencies to rise at a point in the future.
- Futures market: This is similar to the forward market, except, in the futures market, a public commodities market determines the size and settlement dates of the contracts. One of the most common commodities markets in the United States is the Chicago Mercantile Exchange. The National Futures Association regulates the futures market. In the case of a futures contract, the exchange serves the role of being a counterpart to the trader, providing clearance and settlement.
Forex Terms to Know
Here are some common forex terms you show know:
- Leverage: The ratio of buying power you have relative to your cash. Leverage utilized margin to buy more than you have the cash for. Leverage is expressed as a ratio of buying power to cash. Leverage of 100:1 means you can buy $100,000 of currencies for $1,000 cash in your forex account.
- Liquidity: This expresses the ability for a pair to be bought and sold without making much of a material impact because of plentiful supply and demand. Strong liquidity results in a tighter bid and ask spread as more participants are willing to provide a better price just to get filled. Thin liquidity is expressed by wider buy and ask spreads due to lesser participants, supply and demand.
- Long/short: This is the direction of your trade. If you buy a currency, you are long because you only profit if the current rises in value. If you are short a currency, you expect the price to fall to make profits. Short positions can be dangerous because they can form short squeezes causing margin calls and forced liquidations during critical events.
- Lot size: This describes the number of currency units traded. Standard lot sizes are 100,000 units of the base currency. They go smaller to 10,000 units for mini, 1,000 for micro and 100 for nano lot sizes.
- Maintenance margin: This is how much money you need in your account to maintain your open positions. Fulling below maintenance margin levels can result in a margin call.
- Margin call: When your balance falls under the maintenance margin level, you will either have to transfer more cash into your forex account or sell positions to bring the maintenance margin level back down.
- Pip: A pip is the smallest incremental trading unit for a currency. Pip is short for percentage in points or price interest point. While most major currencies have pips worth 0.0001, some currencies, like the USD/JPY have a pip worth 0.01.
- Spot: This is the most popular type of forex trading market. Currencies are bought and sold on the "spot" at current prices for immediate delivery.
- Stop-loss: This is the price level that you will exit the trade to take your losses. Most importantly, it's the cut-off point for your losses, so they don't turn into a larger loss. Stop-losses should be predetermined before you enter a position and must be adhered to if the stop price hits. The discipline to take losses is critical, especially with the high leverage.
How to Trade Forex
Here are five steps to getting started in FX trading.
Step 1: Open and fund a forex brokerage account.
To trade forex, you must have a forex trading account. You can go with pure forex brokers that only offer forex trading or a multi-purpose broker that offers forex in addition to stock, options, futures and cryptocurrency trading. You should inquire about currencies or FX trading if you have an existing brokerage account. Find a new broker if your current one doesn't offer currency pairs.
Accessing your FX account via a mobile app is also important nowadays so you don't have to glue yourself to your monitors while in a trade. Forex markets tend to trend, and price swings can take much longer than you would experience with stocks in the stock market.
Step 2: Select your currency pairs.
Select a currency pair to start with. It helps to be familiar with the currency and the underlying country. Taking a major currency pair is highly recommended due to the liquidity and volatility. If you want to familiarize yourself with a forex stock, you can track the U.S. dollar index (DXY). Start watching the pair throughout the day and the hours it trades at. Get a feel for the price action. It also pays to observe your prey.
Step 3: Perform fundamental and technical analysis.
It's good to read about the underlying country's economy and events for your selected currency. Currencies move based on economic and political events that happen in the world. Fundamental research will involve catching up on current events and potential catalysts. For example, the U.S. Federal Open Market Committee (FOMC) decisions are always a significant event as they set the course for interest rates and monetary policy for the U.S., impacting the U.S. dollar.
Apply technical analysis to the currency using charts and indicators of your preference. For example, a candlestick chart on the five-minute, 60-minute and daily time frames with an RSI indicator and 20-period exponential moving average and a 50-period simple moving average is an adequate set-up. Spot price patterns like flags, triangles, cups, handles and pennants. Observe the trends and the support and resistance levels for the time frames.
Step 4: Plan the trade.
As you get more familiarized with the currency, you can begin to strategize about a trade. Use the trend, support and resistance levels and the momentum indicator to determine adequate price levels for entry, exit and stop-loss. Make sure your allocation is comfortable, and you don't go all in and jeopardize yourself.
Step 5: Execute and manage the trade.
Administer the patience to let the trade come to you and the discipline to apply risk control and execute stop-losses when triggered. Forex is one of the main trading instruments that can use a tangible risk management strategy of units. Some traders will only enter a trade if there is a one-risk-to-two reward unit probability.
Example of a Forex Trading Strategy
As with all financial markets, trading instruments move in a four-part sequence. An asset will break (breakout or breakdown), trend (uptrend or downtrend), pullback/reverse, consolidate and repeat. A trading strategy will capitalize on any part of the market action sequence. Some strategies will focus on catching breakouts, others focus on catching trends on pullbacks, while others focus on trading the countertrend reversions and trend reversals.
In the EUR/USD chart, you can execute a reversion/reversal strategy. The daily chart formed a cup and handle breakout. The EUR/USD was in a downtrend in May 2023. It continued to drift lower until hitting a low of $1.0635 on May 31, 2023. The next day, it made a higher low of $1.0661. This sets up the market structure low (MSL) buy trigger above the high of the higher low candle, which is $1.0768.
The relative strength index (RSI) also starts to bounce higher from the 35-band after May 31, 2023. A long would be bought at $1.0769 on Jun 13, 2023, when the MSL trigger buy triggers. The stop-loss would be triggered by the recent low breakdown of $1.0635. The exit would be based on either a market structure high (MSH) trigger sell or at the re-test of the cup lip line at $1.1004, completing the reversal trade strategy on the daily EUR/USD.
Pros and Cons of Forex Trading
Here are some pros and cons of forex trading.
Here are some of the benefits of forex trading:
- Market liquidity: The forex market is the world's largest and most liquid financial market. This doesn't mean every currency pair is liquid. The major pairs are the most liquid, so it's best to stick with them when you begin.
- Market access: The forex markets are technically available to trade 24 hours a day and five days a week. Of course, not every currency should be traded around the clock, as liquidity evaporates during non-active hours. The 24-hour time element accommodates the different time zones and economies that operate in them.
- Low barriers to entry: You can open forex accounts for as little as $50. Of course, that leaves little room for error as new traders should be well capitalized with risk capital. It's also much simpler to follow a few currency pairs than try to manage a watchlist of 50 stocks. Keeping track of earnings beats and misses, conference calls, and analyst ratings changes can be strenuous.
- Commission-free: This can be misleading because brokers tend to make their "commission" in the spreads. While FX trading is technically commission-free, you pay a higher price based on the slightly wider spreads on the quoted currency pairs.
Here are some of the downsides to forex trading:
- Complex fundamentals: Forex trading can be complicated, especially when attempting fundamental analysis. There are many potential catalysts to trigger a sharp move in currencies, so it means constantly staying abreast of economic and political news for both countries in the pairs that you trade. You should know the various government reports like the consumer price index (CPI), labor, unemployment, housing starts, retail spending, GDP and FOMC beige book. Mark the Federal Open Market Committee (FOMC) meeting announcement dates on your calendar as they impact interest rates.
- Heavy leverage: FX trading usually requires leverage because the incremental moves are microscopic. With any case of high leverage, there are always dangers of an unexpected event that sends currencies spiking or collapsing. This can result in painful margin calls requiring more cash you may not have available.
- Inconvenient trading hours: The counter to market access is the unusual trading hours for some currencies, even the majors. If you're a morning person, you likely won't favor trading evening hours when the Aussie dollar and Japanese yen trade. If you're an evening person, you won't like trading the U.K. pound sterling or the euro.
- Scammers: Since FX trading has blown up and penetrated the mainstream, it also contains many potential scammers. These can involve Ponzi schemes, pump and dump, automated trading systems and expensive trading courses. Be on your toes and try to research as much as possible into any vendors or brokers you transact with.
Be Aware of Time Zones
The forex market is open 24 hours a day to accommodate the time zones of countries' currencies worldwide. While you can trade FX around the clock, choose which sessions you want to trade. If you prefer to trade Asian currencies like the yen, you should prepare to wake up early since they are 13 hours ahead of the U.S.
While the yen trades around the clock, most of the action and liquidity tend to anchor around their market hours. If you prefer trading forex early in the morning, consider trading the euro. London is five hours ahead of the U.S. It's important to know when forex markets open based on region.
The four major foreign exchange market trading sessions include Sydney, Tokyo, London and New York.
- The world forex markets start with Sydney at 5 p.m. Eastern Standard Time (EST) until midnight.
- The forex market in Tokyo opens at 7 p.m. EST to 4 a.m.
- The European sessions open at 2 a.m. and close at 10 a.m. in Frankfurt, Germany.
- The London session opens from 3 a.m. EST to 11 a.m.
- North American markets open in New York at 8 a.m. EST to 5 p.m.
The sequence repeats every weekday until 5 p.m. EST on Friday. Forex markets resume trading on Sunday evenings at 5 p.m. EST in Sydney, Australia.
Here are answers to some frequently asked questions about forex trading meaning and more.
How do forex traders make money?
Forex traders profit from trading price fluctuations in currency pairs. Forex trading has no uptick rules like stocks, which means pairs can be short-sold just as easily as taking a long position. While FX trading can appear to be easy, there are numerous cases of people blowing up their accounts due to a lack of trading strategy, impulse trading, lack of discipline and overleveraging. Don't look for "What is the best currency to trade in forex?" but focus on a handful of pairs.
How can a beginner trade in forex?
Beginning forex traders should learn about the currency pairs and the underlying country's economic and political condition. Build a foundation for forex trading and how forex works. Follow the five steps outlined in this article about how to trade forex. It is also beneficial to start practicing on a demo or free simulator before dealing with real cash. Many forex brokers provide this feature for funded accounts.
How much money do I need to trade forex?
Starting account minimums vary between brokers, ranging from $50 to $5,000 for currency forex trading. While it may seem tempting to start forex trading with $50, the reality is that you will be severely underfunded and limited with an amount that small. Fund a forex account with at least $5,000 to $10,000 of pure risk capital.