The foreign exchange market (also known as forex or FX) is the market where foreign currencies are exchanged. Forex is the largest market in the world, and its trades influence everything from the cost of Chinese-imported clothing to the price of a margarita while on vacation in Mexico.
What Is the Forex Market?
A trader buys one currency and sells another, and the exchange rate fluctuates continuously in response to supply and demand.
The foreign exchange market is a global market accessible 24 hours a day, Monday through Friday, where currencies are traded. All forex trading is conducted over-the-counter (OTC), which means there is no physical exchange (as there is for stocks) and a global network of banks and other financial institutions supervise the market (instead of a central exchange, such as the New York Stock Exchange).
The overwhelming majority of forex trading is conducted between institutional traders, such as those employed by banks, fund managers, and multinational corporations. These dealers may simply be speculating on or hedging against future exchange rate fluctuations and have no intention of taking physical possession of the currencies themselves.
A forex trader might purchase U.S. dollars (and sell euros) if she expects the dollar’s value to rise and, as a result, be able to purchase more euros in the future. In the meantime, an American company with operations in India could use the foreign exchange market as a hedge in the event that the rupee diminishes, resulting in a decline in the value of its income generated in India.
How Currency Exchanges Occur
Each currency has a three-letter identifier, similar to a stock’s ticker symbol. While there are more than 170 currencies in the world, the U.S. dollar is involved in the overwhelming majority of forex trading, so knowing its code is particularly useful. USD. The second most popular currency on the foreign exchange market is the euro (code: EUR), which is recognized in 19 countries within the European Union.
The Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF), and the New Zealand dollar (NZD) are also prominent currencies.
All foreign exchange transactions are expressed as a combination of the two currencies involved. The following seven currency combinations, known as the majors, account for approximately 75% of forex market trading.
- EUR/USD
- USD/JPY
- GBP/USD
- AUD/USD
- USD/CAD
- USD/CHF
- NZD/USD
How Currency Exchanges Are Quoted
Each currency combination represents the two currencies’ current exchange rate. Here’s how to interpret that information, using EUR/USD as an illustration.
- The leftmost currency (the euro) is the fundamental currency.
- The currency on the right (the United States dollar) is the currency being quoted.
- The exchange rate is the amount of the quoted currency required to purchase one unit of the base currency. Consequently, the base currency is always expressed as 1 unit, whereas the quote currency fluctuates based on the current market conditions and the amount required to purchase 1 unit of the base currency.
- If the EUR/USD exchange rate is 1.2, then €1 will purchase $1.20 (or it will cost $1.20 to purchase €1).
- When the exchange rate rises, it indicates that the base currency has increased in value relative to the quote currency (since €1 will purchase more U.S. dollars), and when it declines, it indicates that the base currency has decreased in value.
A brief note: Generally, the base currency comes first and the quote currency comes second when presenting currency pairs. However, there are historical conventions that dictate how some currency pairs are expressed. For instance, conversions from USD to EUR are listed as EUR/USD, not USD/EUR.
Three Methods for Trading Forex
The majority of forex transactions are not conducted for the purpose of exchanging currencies (as one would do at a currency exchange while traveling), but rather to speculate on future price movements, similar to stock trading. Similar to stock traders, forex traders attempt to purchase currencies whose values they believe will rise relative to other currencies and sell currencies whose purchasing power they believe will fall.
There are three methods to trade forex, accommodating traders with varying objectives:
- The current market. This is the primary foreign exchange market where currency pairs are exchanged and exchange rates are determined in real-time based on supply and demand.
- The futures market. Instead of executing a trade immediately, forex traders can enter into a legally binding (private) contract with another trader to lock in an exchange rate for a predetermined quantity of currency at a future date.
- The futures exchange. Traders may also choose a standard contract to purchase or sell a predetermined amount of a currency at a specified exchange rate at a future date. This is conducted on an exchange as opposed to privately, as in the forwards market.
The forward and futures markets are primarily utilized by forex speculators who wish to speculate on or hedge against future currency price fluctuations. The exchange rates in these markets are determined by the spot market, which is the largest of the forex markets and where the majority of foreign exchange transactions are executed.
Currency Terms to Learn
Each market has its own native tongue. These terms must be understood prior to engaging in forex trading.
- Combination of two currencies. Every forex transaction includes a currency pair. There are also less common transactions (such as exotics, which are currencies of developing countries) in addition to the majors.
- Pip. A pip, which is an abbreviation for percentage in points, is the smallest conceivable price change within a currency pair. A pip is equal to 0.0001 because forex prices are quoted to at least four decimal places.
- Bid-ask disparity. As with other assets (such as stocks), exchange rates are determined by the highest price purchasers are willing to pay for a currency (the bid) and the lowest price sellers are willing to accept for the currency (the ask). The difference between these two prices, and the price at which transactions will ultimately be executed, is known as the bid-ask spread.
- Lot. A lot, which is a standard unit of currency, is used to transact foreign exchange. The standard lot size is 100,000 units of currency, but micro (1,000) and mini (10,000) quantities are also available for trading.
- Leverage. Due to the enormous lot sizes, some traders may be unwilling to execute a trade with so much capital. Leverage, which is another term for borrowing money, enables traders to partake in the foreign exchange market without the requisite amount of capital.
- Margin. Trading with leverage is not, however, without cost. Traders are required to make an initial deposit, also known as a margin.
What Influences the Forex Market?
Similar to any other market, currency prices are determined by supply and demand. However, other macro forces are also at work in this market. Additionally, interest rates, central bank policy, the rate of economic growth, and the political climate of the country in question can affect the demand for particular currencies.
The foreign exchange market is open 24 hours a day, five days a week, allowing speculators to react to the news that may not affect the stock market until much later. Given the importance of speculation and hedging in currency trading, it is crucial for traders to understand the dynamics that can lead to abrupt currency fluctuations.
Risks of Foreign Exchange Trading
Because forex trading requires leverage and traders use margin, there are greater risks associated with forex trading compared to other asset classes. Currency prices fluctuate continuously, but only by minute amounts, requiring traders to execute large trades (using leverage) in order to profit.
This leverage is advantageous if a trader wins a wager because it magnifies profits. However, it can also magnify losses, even to the point of exceeding the amount initially borrowed. In addition, if a currency depreciates excessively, leverage users risk margin calls, which could compel them to sell securities acquired with borrowed funds at a loss. In addition to potential losses, transaction costs can accumulate and cut into a profitable trade.
In addition, you should bear in mind that those who trade foreign currencies are small fish in a pond of skilled, professional traders, and there may be fraud or information that could confuse new traders.
Perhaps it’s a good thing that forex trading among individual investors is uncommon. According to data from DailyForex, retail trading (also known as trading by non-professionals) accounts for only 5.5% of the entire global market, and some of the largest online brokers do not even offer forex trading. Moreover, the majority of retail merchants who engage in forex trading struggle to generate a profit. CompareForexBrokers discovered that 71% of retail FX traders lost money on average. This makes forex trading a strategy that is frequently best left to the experts.
