What is Forex?
Forex, also known as foreign exchange, FX or currency trading, is a decentralized global market where all the world’s currencies trade. The forex market is the largest, most liquid market in the world with an average daily trading volume exceeding $5 trillion. There is no central exchange as it trades over the counter. Forex trading allows you to buy and sell currencies, similar to stock trading except you can do it 24 hours a day, five days a week, you have access to margin trading, and you gain exposure to international markets. For a more in-depth introduction to the forex market, get FXCM’s New to Forex Trading Guide.
Learning to trade in a new market is like learning to speak a new language. It’s easier when you have a good vocabulary and understand some basic ideas and concepts. So let’s start with the basics of forex trading.
What Am I Doing When I Trade Forex?
Forex is a commonly used abbreviation for “foreign exchange”, and it is typically used to describe trading in the foreign exchange market by investors and speculators.
What is Forex?What is Forex? video for FXCM1:54
Imagine a situation where the U.S. dollar is expected to weaken in value relative to the euro. A forex trader in this situation will sell dollars and buy euros. If the euro strengthens, the purchasing power to buy dollars has now increased. The trader can now buy back more dollars than they had to begin with, making a profit.
This is similar to stock trading. Stock traders will buy a stock if they think its price will rise in the future and sell a stock if they think its price will fall in the future. Similarly, forex traders will buy a currency pair if they expect its exchange rate will rise in the future and sell a currency pair if they expect its exchange rate will fall in the future.
Forex Transaction: It’s all in the Exchange
If you’ve ever traveled overseas, you’ve made a forex transaction. Take a trip to France and you convert your dollars into euros. When you do this, the exchange rate between the two currencies—based on supply and demand-determines how many euros you get for your dollars. And the exchange rate fluctuates continuously. A single dollar on Monday could get you .70 euros. On Tuesday, .69 euros. This tiny change may not seem like a big deal. But think of it on a bigger scale. A large international company may need to pay overseas employees. Imagine what that could do to the bottom line if, like in the example above, simply exchanging one currency for another costs you more depending on when you do it? These few pennies add up quickly. In both cases, you—as a traveler or a business owner—may want to hold your money until the exchange rate is more favorable.
What Is An Exchange Rate?
The foreign exchange market is a global decentralized marketplace that determines the relative values of different currencies. Unlike other markets, there is no centralized depository or exchange where transactions are conducted. Instead, these transactions are conducted by several market participants in several locations. It is rare that any two currencies will be identical to one another in value, and it’s also rare that any two currencies will maintain the same relative value for more than a short period of time. In forex, the exchange rate between two currencies constantly changes.
For example, on January 3, 2011, one euro was worth about $1.33. By May 3, 2011, one euro was worth about $1.48. The euro increased in value by about 10% relative to the U.S. dollar during this time.
Why Do Exchange Rates Change?
Currencies trade on an open market, just like stocks, bonds, computers, cars and many other goods and services. A currency’s value fluctuates as its supply and demand fluctuates, just like anything else.
An increase in supply or a decrease in demand for a currency can cause the value of that currency to fall.
A decrease in the supply or an increase in demand for a currency can cause the value of that currency to rise.
A big benefit to forex trading is that you can buy or sell any currency pair, at any time subject to available liquidity. So if you think the Eurozone is going to break apart, you can sell the euro and buy the dollar (sell EUR/USD). If you think the price of gold is going to go up, and based on historical correlation patterns, you think the value of gold affects the value of the Australian dollar, you might decide to buy the Australian dollar and sell the U.S. dollar (buy AUD/USD).
This also means that there really is no such thing as a “bear market,” in the traditional sense. You can make (or lose) money when the market is trending up or down.
Elements of a Forex Trade
How Do You Read A Quote?
Because you are always comparing one currency to another, forex is quoted in pairs. This may seem confusing at first, but it is actually pretty straightforward. For example, EUR/USD at 1.4022 shows how much one euro (EUR) is worth in U.S. dollars (USD).
What Is A Lot?
A lot is the smallest trade size available. FXCM accounts have a standard lot size of 1,000 units of currency. Account holders can, however, place trades of different sizes, as long as they are in increments of 1,000 units like 2,000; 3,000; 15,000; 112,000.
What Is A Pip?
A pip is the unit you count profit or loss in. Most currency pairs, except Japanese yen pairs, are quoted to four decimal places. This fourth spot after the decimal point (at one 100th of a cent) is typically what one watches to count “pips.” Every point that place in the quote moves is 1 pip of movement. For example, if EUR/USD rises from 1.4022 to 1.4027, EUR/USD has risen 5 pips.
What Is Leverage
As mentioned before, all trades are executed using borrowed money. This allows you to take advantage of leverage. Leverage of 50:1 allows you to trade with $1,000 in the market by setting aside approximately $20 as a security deposit. This means that you can take advantage of even the smallest movements in currencies by controlling more money in the market than you have in your account. On the other hand, leverage can significantly increase your losses. Trading foreign exchange with any level of leverage may not be suitable for all investors.
The specific amount that you are required to put aside to hold a position is referred to as your margin requirement. Margin can be thought of as a good faith deposit required to maintain open positions. This is not a fee or a transaction cost, it is simply a portion of your account equity set aside and allocated as a margin deposit. Learn more about FXCM’s