What is forex trading?

The Forex (foreign exchange) market is the largest financial market in the world with a daily volume of $5 trillion. It also serves as the primary exchange mechanism for global business and trade.

Forex Explained

  • What is Forex?

    The Forex (foreign exchange) market is the largest financial market in the world with a daily volume of $5 trillion. It also serves as the primary exchange mechanism for global business and trade. With such a large daily transaction volume, the Forex market offers a wide variety of trading opportunities for people looking to capitalize on the fluctuations of currency values. Forex traders buy and sell different currencies 24 hours a day, 6 days a week, and access increased leverage (purchasing power) in order to speculate on global currency flows and market volatility.

    The Foreign Exchange market is commonly referred to as Forex or FX, and it is a worldwide, decentralised, over-the-counter financial market for the trading of currencies.

    Worldwide

    • It's a worldwide market because you are looking at the relative value of one countries currency against another.

    • Global and political events drive these markets, in turn affecting the relative values of a countries currency, which in turn changing the value of the currency pairs.

    Decentralised

    • Decentralised means there is no centralised exchange, unlike say, the stock market.

    • Instead the Financial centres around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

    Over the counter (OTC)

    • The currency market isn't controlled by any central governing body, and there are no clearing houses to guarantee the trades.

    • Brokers and dealers negotiate directly with one another through electronic networks.

    • A market in which dealers negotiate prices amongst them is referred to as Over The Counter

    Trading forex

    For active traders, the Forex market should be no different than other trading products, such as equities, commodities, or fixed-income. Forex offers traders a market where they can buy or sell a trading product. In this case, it is a specific currency pair. The currency pair may be the Euro versus the US Dollar, the US Dollar versus the Japanese Yen, the British Pound versus the US Dollar, the Euro versus British Pound, or a number of other currency combinations.

    The different currency combinations represent the value of one currency versus the value of another. That relationship is represented by a single price. In foreign exchange, the price of a currency pair is the market's expectation (at that time) of the value of that currency measured against another currency, given the current and expected economic and political situation in the two economies. In equity terms, it is similar to the price of the stock.

    How does it compare to other markets

    While the stock markets have a daily volume in the billions of dollars, the Forex market has a daily volume of more than $4 trillion. Forex market participants include large banks, hedge funds, and other financial institutions, global corporations, and individual traders. The majority of Forex transactions are the result of currency conversions related to the day to day business of the world. The large daily volume of the Forex market provides endless trade opportunities and the ability for traders to diversify into global currency markets.

    What factors come into play when deciding how to trade Forex? How does that compare with trading equities? Let's say, for example, that an economy's inflation rate or interest rates are low and stable, its output is growing strongly, and its politics are stable. One can expect for that country's currency to remain strong versus a less fundamentally favorable currency.

    Now, let's compare that with an equity of a particular company. If the domestic and global economy is strong, inflation is not rampant, competition is not taking away market share, product demand is stable, and workers are productive, then you can expect that company's stock to remain strong versus a company with less favorable fundamentals.

    Similar to equities, there are other factors that determine the short-term value of a Forex currency pair, including technical analysis, short-term supply and demand, seasonal capital flow patterns, the current price of the instrument, etc. It is these universal dynamics that will move a currency's value up or down. Open a live ThinkMarkets account to start trading Forex today.

  • Market Movers

    Now you have seen the main 'players' within Forex (market participants) we can look at reasons for market prices to move.

    Remember that it is the major players who account for the vast majority of money flows - and it is the flow of money from one currency to another that causes prices to fluctuate and create trends across various markets. Whilst the actual money flow could be for speculative reasons, hedging for protection for clients, or purchasing assets, expectations of changes in monetary flows also play a big part.

    These expectations from the participants could come from changes in GDP (gross domestic product), inflation, interest rates, budget and trade deficit/surplus, along with other macroeconomic conditions.

    Potenially volatile news events

    • GDP (Gross domestic product)

    • Interest Rates

    • Employment/unemployment

    • Trade deficit and surplus

    • Force majeure (Worldy events)

    Nonfarms payroll and unemployment rate

    The most closely watched news release is the US Nonfarms payroll and unemployment, as it can create a lot of volatility during and after the release. Watch the webinar below for an in depth tutorial on why this is such an important news event.

    Economic calendar

    So how do we monitor these potential market movers? Whilst we cannot forsee worldly events we can use an economic calendar to monitor which important news releases are scheduled for the days, weeks and months ahead.

    Economic calenders highlight publicly released news for specific countries, meaning people around the world have access to the same news at the same time. Whilst this is great for retail traders like ourselves it is also good to realise that the banks have one major advantage - they can see their clients order flows to see where money is flowing into (and out of).

    Market movers

    Market sentiment

    Sentiment can be used for both long and short term traders. For those on a longer time horizon they are likely to look at trends of the data over weeks and months and compare this alongside prices of relevant currency pairs.

    Below is Canadian CPI, which is a proxy for inflation. Here we can see CPI is within a downtrend to suggest deflation. The Canadian dollar (at the time of writing) is also within a downtrend along with CPI. If we were to notice that a negative CPI figure was released, or a series of them released yet price failed to trade much lower, this is a suggestion that the markets bears may have begun to hibernate, and price could reverse over the coming days, weeks or months.

    A short-term trader would see that the next release has a consensus (expectations of many analysts) of an average of 1.3%. At the time of the release if we get a deviation away from this 'expectation' we can expect a larger market move around the release as this is considered to be a surprise to the market.

    Market movers

    News trading

    This is a very popular form of trading within Forex. These traders specialise in trading at or around the news release and similar to the example above, they seek deviations away from the expectations to seek more volatile moves.

    Let us take an example of a news trader who specialises in the USDJPY. They would go to the economic calendar and open the filters.

    Market movers

    They would then only select United States and Japan news, push the slider up to the red !!! (to only filter red news events of USD and JPY) then select 'filter results'.

    Market movers

    They would then see high impact news that is likely to affect the USDJPY and they can plan their trading week accordingly, knowing when they can expect some sort of market movements, or at the very least prepare a trading plan in the event of a market movement.

    Market movers

    Anti-news trading

    The 3rd approach, and possibly less exciting, is to use the same techniques to filter for high-impact news and make sure you do not place trades at this time. This is more suited to traders who used the 1hr, 4hr and daily charts to enter their trades (or 'set and forget').

  • FX Pairs

    In the Forex market, traders hope to generate profits by speculating on the value of one currency compared to another. Currencies are always traded in pairs in many combinations, thus offering opportunities to profit from exchange rates between various global currencies.

    Forex quotations

    The exchange rate prices offered to traders are referred to as Quotes.

    A quote comprises of

    • Base Currency: This is the first currency in the pair. The exchange rate listed represents how much of the second currency one unit of the Base currency will be able to purchase.

    • Counter Currency: This is the second currency in the currency pair.

    Example

    For example, suppose the buy quote (meaning the price traders can buy at) on EUR/AUD is 1.44000. This means that 1 Euro (the base currency) can purchase 1.44000 Australian dollars (the second currency, or counter currency). Likewise, if we saw a GBP/JPY price of 171.158, this would tell us that 1 British pound (GBP) would purchase 171.158 Japanese yen (JPY).

    When the exchange rate is rising, it tells us that the base currency is rising relative to the counter currency. When the exchange rate is falling, the opposite is true: the counter currency is rising relative to the base currency.

    The chart below illustrates.

    Forex quotations
    Forex quotations

    Practice trading on a free ThinkMarkets demo account to see these exchange rates move. Or to continue your education in forex trading, see our guides.

  • Pips

    What is a pip?

    • A "pip" is the smallest whole increment in any Forex pair.

    • For pairs quoted in 3 decimal points a pip increment is based on the second decimal.

    Read more
  • Leverage and Margin

    What is margin?

    Margin is the amount required to open a new Forex position. It is not a fee, nor is it a charge to your account. Rather, it serves to ensure that you have a sufficient account balance relative to the size of your position. Margin is the inverse of leverage.

    The exact amount traders need in their account to put on a position depends on the size of their position and what instrument they are trading. On our contract specifications page, the amount of leverage required for each position is displayed; margin is simply the inverse of this. For instance, leverage on AUDJPY is listed as 500:1. This means that traders can trade up to 500X the equivalent amount of Australian dollars they have in their account. If a trader puts on a one lot position in AUDJPY (where one lot equals 100,000 AUD) then a trader's margin requirement is 200 AUD. That means that a trader must have 200 AUD (or the equivalent of that amount in another currency) to open a 100,000 AUD position. If the floating value of a trader's account falls below their margin requirement, the broker may close the position.

    It is common advice to use leverage with prudence and caution. Significant leverage can just as easily result in great losses as it can in great gains.

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