What is Forex Trading and How Does it Work

The Global Forex Marketplace

The global foreign exchange market is responsible for over $7.5 trillion in currency transactions every day - a total that is many times larger than every stock exchange in the world combined. This trading occurs 24 hours a day, five days per week, from Sydney to Tokyo to London to New York, with Forex (Foreign Exchange) being a decentralised market for trading currencies.

Forex is traded over-the-counter (OTC), meaning that there is no specific centralised trading venue. Forex dealers and brokers operate through an intricate network of banks, brokers, large corporations, and increasingly, retail consumers and small businesses who use smartphones and relatively small amounts of capital.

The mechanics of the Forex market are rather simple. Most trades will involve a currency pair, such as the euro versus the U.S. dollar (EUR/USD) or the British pound versus the Japanese yen (GBP/JPY). For example, suppose an investor has purchased euros at 1.0850 and, then, after some time, the price of the euro has increased to 1.0920. In this case, the investor made a profit on the difference between the two prices. In general, currency prices change according to supply and demand for each currency and, ultimately, all of these factors influence the movement of currency prices.

The economic forces influencing currency prices are numerous, but interest rates are the most powerful driver of Forex prices. Whenever a central bank increases the base interest rate (the benchmark), it causes an influx of foreign capital, which increases the demand for that currency.Between 2022 and 2023, the US Federal Reserve aggressively raised rates and pushed federal funds rates from close to zero (%) to over 5.0%. As a result of this rate-hiking cycle, the US dollar index (DXY) surged to an all-time high of 120 in September '22, while the Japanese yen plunged to a 15 year low of around ¥150/$1 due to the Bank of Japan keeping rates in negative territory. The above examples are excellent illustrations of how interest rate differentials affect currencies.

Currency valuations are affected by inflation, GDP growth, trade balances, and other measures of a country's political stability. For example, when the UK voted to leave the EU in June 2016 (Brexit), the value of the British pound (GBP) dropped over 10% versus the US dollar (USD) in one session, creating a significant amount of uncertainty regarding the future performance of the UK economy. This shows how the forex market acts as a constant referendum on the overall economic health of a country.

Core Concepts of Forex Trading

Forex trading always occurs in pairs, because one currency is converted into another currency. A currency pair consists of two currencies: a base and a quote. The base currency is the first currency listed in the currency pair, and the quote currency is the second currency listed in the currency pair. For example: In the currency pair EUR/USD the base currency (the first listed) is euro (EUR) and the quote currency (second listed) is United States dollar (USD). If EUR/USD is trading at 1.1000, that means for every one euro exchanged, you will get 1.10 United States dollars.

Forex pairs are typically classified into three primary categories. Major pairs consist of the most actively traded currencies worldwide and nearly always contain the United States dollar in them, i.e., EUR/USD; USD/JPY etc. Minor pairs are sometimes referred to as cross-currency pairs and do not contain the United States dollar, for example, EUR/GBP, AUD/NZD etc. Exotic pairs are formed when a major currency is combined with the currency of a smaller or developing economy, for instance, USD/TRY; EUR/ZAR etc. Major pairs generally have the most liquidity and lowest costs associated with trading while exotic pairs tend to be more volatile compared to major pairs.

The Forex market measures price movement using pips, which represents the smallest standard price movement in most currency pairs. For most currency pairs one pip is equal to 0.0001 while the pairs with the Japanese yen will be quoted to two decimal places making one pip equal to 0.01. The amount of gains and losses and transaction fees on trades will depend on the number of pips.

Trade size is measured in lots which allows the standardisation of the amount of currency either bought or sold each trade. A standard lot represents 100,000 units of a base currency. Mini; micro and nano lots allow traders to take the same position at a much smaller size. The trade size you choose to use will affect the amount of money you can make and the financial risk/damage you may incur in each trade.

Forex is traded on various different market types. The spot market is where the most retail trades occur through immediate conversions of a currency via spot pricing. The forward market allows traders to lock in rates of exchange for a future date so that they are protected from currency risk. The futures market consists of standardised contracts listed on regulated stock exchanges, and the options market give traders the right but not the obligation to buy or sell a currency at a given price before a specified date.

All traders will use their own trading strategies dependent on their own risk tolerance and goals. There are trend following strategies in Forex, where traders want to utilise extended price movements, and range trading strategies where price stays within known support and resistance levels. Swing traders will look for medium-term movements in price over several days, and scalpers will look for several small price movements over a few minute time frame. Most successful traders will use technical indicators, combined with knowledge of economic factors to help determine how to trade.

Who Are Forex Market Participants and Why?

The range of participants in the forex market includes central banks that monitor and manage their countries' reserve holdings and multi-national corporations that hedge currency risk from revenues earned in foreign countries. For example, if a UK-based manufacturer were to export products to the United States, the company may want to hedge against fluctuations in GBP by using forward contracts to lock-in an exchange rate for several months before delivery, thereby protecting the profit margin on the exported products. Hedging like this makes up a large percentage of the forex market volume on a daily basis.

In recent years, retail traders have begun taking an increasingly larger percentage of volume. According to the Bank for International Settlements (BIS), retail aggregate volumes increased significantly in 2022 from previous years primarily due to the availability of low-cost online brokers and increased access to leverage. Developing in-depth knowledge about forex trading can help retail participants better understand how macroeconomic events, central bank decisions, and market sentiment influence currency prices and trading opportunities. Additionally, many retail participants who wish to acquire extensive knowledge about the forex market often find, through experience, that success in the forex market relies more heavily on understanding the macroeconomic environment affecting the price action than it does on short-term speculation.

Leverage, Risk, and Macro-Level Impacts

Leverage can significantly increase both profit and loss potential for a trader. Most brokers will offer leverage ratios for major pairs of 30:1 (under the European Union Regulation of the European Securities and Markets Authority (ESMA) developed in 2018) — for example, if a trader has a £1,000 trading account, they would be able to control a £30,000 position with that account. It is this significant leverage that draws traders to forex with promises of excessive profit and lends itself to the high likelihood of excessive losses, as studies conducted by US and UK regulators consistently show that 70%-80% of retail-traded clients lose money when trading leveraged products.

In addition to the macroeconomic implications, the volatility of currency exchange rates has repercussions on real-world economies. When a country experiences a decline in the value of its domestic currency, it incurs increased costs on imported goods and services, resulting in rising inflation. Conversely, when a domestic currency appreciates, it puts increased pressure on exporters. As central banks continue to navigate their different monetary policies into the mid-2020s, these feedback loops will become increasingly difficult to ignore.