Those looking to trade other instruments apart from stocks can consider forex investments instead. This is the buying and selling of one currency into another. In this article, we take a look at what forex trading entails, how the forex market functions, what makes up a currency pair, and factors that impact the forex market. Keep reading below to learn more.
What is forex trading?
Forex, which is a portmanteau of the term foreign exchange, refers to the conversion of currencies in the search for potential profits. More specifically, it is how individuals, central banks, companies, and other organizations convert one currency into another. Forex trading can also be used as a way to hedge against exchange rate fluctuations. As a result of so many currencies being converted every single day, it can make the price movements of some currencies very volatile. While extremely risky, this volatility also brings upsides to traders – it can be a great way to find and take advantage of new opportunities that crop up.
How does the forex market work?
Unlike commodities or stocks, forex trading does not happen on exchanges. Instead, it happens directly over-the-counter (OTC) between two parties. The forex market – where this takes place – is run by a global network of banks, which are spread across various time zones in financial regions around the world, such as New York, Sydney, Tokyo, London and more. As so many trades take place in the forex market each day, the forex market is the largest and most active financial market in the world. As there is no central location where trades specifically take place, the forex market is open 24 hours a day, 5 days a week.
There are three different ways for traders to trade currencies:
Spot forex market: This is the primary way currency pairs are traded, as they are bought and sold at their current trading price. This price is determined by supply and demand, as well as other factors such as economic performance, current interest rates, price speculations, and more.
Forward forex market: This contract is a private agreement between two parties to purchase a currency at a predetermined price at a future date. The two parties are the ones who determine the terms of the agreement.
Future forex market: Similar to the forward contract, a futures contract is instead a standardised agreement on a dedicated exchange between two parties to purchase a currency at a predetermined price at a future date. Unlike forwards, futures contracts are legally binding.
Define the base and quote currency
Before beginning to trade forex, traders must understand the difference between the base and quote currency in a currency pair.
The base currency refers to the first currency that is listed in a forex pair. The second currency is the quote currency. As forex trading always involves the selling of one currency to purchase another, this is why they are always quoted in pairs. The price of the forex pair indicates to traders how much one unit of the base currency is worth in the quote currency.
Each currency pair is also listed in a three-letter code. For example, GBP/USD refers to a currency pair involving the purchase of the British Pound and the selling of the US dollar.
Currency pairs tend to be split into a few different categories. They are:
Major pairs: These pairs tend to account for around three-quarters of all trading done in the forex market. They are USD/JPY, EUR/USD, AUD/USD, GBP/USD, USD/CHF, USD/CAD and NZD/USD.
Minor pairs: These are any currency pairs containing currencies outside the major currencies, for instance, USD/SGD.
Exotics: This involves a major currency against one from a smaller or emerging economy. Some exotic pairs include GBP/MXN, EUR/CZK, and USD/PLN.
Regional pairs: Much as their name suggests, these pairs are classified by region, for instance, Australasia or Scandinavia. This can include currency pairs like AUD/NZD, AUD/SGD, and EUR/NOK.
Factors that impact the forex market
As the forex market is made up of various currencies around the world, the forex market is incredibly volatile and prone to price changes. This makes it difficult for traders to make exchange rate predictions since there are so many factors that could potentially influence a currency’s price. That said, similar to most financial markets, the forex market is primarily driven by supply and demand. However, it is still vital for traders to gain an understanding of elements that could potentially influence price fluctuations in the forex market.
News reports
Retail investors and financial institutions such as central banks look to put their funds into economies that look to be performing strongly. As such, if a positive piece of news about a particular region hits the markets, it will likely encourage investments, thereby increasing the demand for that region’s currency.
Conversely, a piece of negative news will likely cause investments to drop, thereby decreasing the region’s currency price. This is why currencies tend to showcase the reported economic health of a region they represent.
Market sentiment
Market sentiment refers to a trader’s reaction to the news. This can play a major role in driving currency prices. For instance, if traders believe that a currency will move in a particular direction, they are likely to trade accordingly. They may even convince their peers to follow what they do, thereby increasing or decreasing the demand for a particular currency.
Central banks
A currency’s supply is mainly controlled by the central banks. These establishments can announce measures that will significantly influence a currency’s price. For example, quantitative easing, which is when central banks inject more money into an economy, can cause the region’s currency price to drop.
Other terminologies to know
Pips: A pip in forex usually indicates a one-digit movement in the fourth decimal place of a currency pair. A price movement in the fifth decimal place is known as a pipette. The exception to this rule is when the Japanese yen is the quote currency. Here, the pip is instead the one-digit move in the second number after the decimal point.
Bid-ask spread: This refers to the difference between the buying and selling price of a currency pair. Having a high spread means there is a large difference between the buying and selling price. On the other hand, having a low spread means there is a small difference between the buying and selling price. The spread is usually measured in pips.
Margin: A margin is a deposit that is needed for traders to use leverage when they are forex trading.
Leverage: Leverage is when traders use borrowed money to invest. By borrowing money from their brokers, traders can trade a larger position in a currency, while only needing to pay a fraction of the price. While leverage can be advantageous for investors, it is important to remember they also amplify risks as well. This is because losses are not calculated based on the initial margin paid by the trader, but instead, the entire position. This means if a trader is not careful, their losses could outweigh their initial investments.
Bottom line
Overall, forex trading can provide traders with plenty of opportunities, provided they understand how to manage risk and leverage. This is due to how dynamic and active the forex market is, with plenty of price quotes changing constantly. The forex market is also heavily influenced by other outside factors such as news events, market sentiment, and more, meaning traders need to keep up-to-date with current events to stay ahead of the market.
