Forex, or foreign exchange, is the process of exchanging one currency for another. Even if you’re not an adventurous investor, you may have done this when traveling to a country with another currency.
But when it comes to trading currency for profit rather than pleasure, the process gets a little more complex. Before seeking riches in this global market, it’s important to understand what it is, how it works – and how to protect yourself.
Currency is an essential element of every modern economy. It allows individuals to buy goods and services directly, rather than barter them. The value of each unit of currency varies based on:
If you want to buy across international borders or trade currency, you’ll need the services of a currency exchange. That’s where the forex market comes in.
The forex market is where currencies are exchanged and traded. It’s open 24 hours per day, 5.5 days a week across multiple time zones. The bulk of forex trades occur in major global financial centers like New York, London, Hong Kong, Paris and Tokyo.
Because it’s so widespread, the forex market doesn’t operate from a central marketplace. Trades are conducted over-the-counter (OTC) electronically via a network of interbank trading terminals and computer networks.
As an international forum operating near-continuously, the forex market is the largest in the world by trading volume. Retail investors, institutional investors, international businesses and banks all participate to varying degrees. (In fact, just ten banks are responsible for well over half of the world’s trading volume.)
Because of its saturation, the forex market is both highly liquid and highly volatile, with prices and currencies moving nonstop. Business operations, institutional trading, geopolitical events, major disruptions and even natural disasters can all generate trading opportunities on a dime.
That leaves plenty of occasions to hedge your bets or speculate on future price movements – if you know what you’re doing.
Forex currency trading is essential because it allows individuals, businesses, banks and governments to pay for goods and services in other economies. When you buy a product in another currency or exchange cash to go on holiday, you’re trading forex.
The forex market provides other opportunities, too: namely, a way for investors to profit off forex exchange rate changes through buying and selling global currencies.
Admittedly, most forex trading is done by massive institutions or international businesses with millions or billions in tradable assets. These firms may hedge against financial risk or speculate about price changes by trading specific currency pairs.
But retail investors can also participate in the market in similar ways (though on a much, much smaller budget).
For instance, you might buy U.S. dollars and sell euros if you think that the dollar will rise in value. But if you think the euro will be king, you might hedge against a cheaper dollar by shorting USD.
In forex parlance, each currency goes by a three-letter code, such as USD for United States dollars or EUR for the euro. Every trade occurs in pairs, written in terms of which currencies you’re exchanging like so: EUR/USD.
In this format, the left-hand currency is called the “base currency.” The right-hand currency is the “quote currency” or “counter currency.”
When trading, you can either buy or sell the base currency. For instance, if you’re buying the euro and selling the dollar, you’d say you’re buying the EUR/USD pair. But if you’re selling the euro and buying the dollar, you’d write that you’re selling the EUR/USD pair.
It’s important to note that the base currency is always equal to one unit of currency. You’ll also have an exchange rate – say, 1.5 In a EUR/USD trade, that means that 1 euro (the base currency) will buy $1.50 (the quote currency).
A rising exchange rate means that the base currency is more expensive relative to the quote currency. In our EUR/USD example, that means 1 euro would buy even more USD. But a falling exchange rate means that the base currency purchases less of the quote currency.
The forex market also relies on bid and ask prices that represents the dealer’s position.
The bid price is the price at which you sell the base currency. (The dealer “bids,” or pays, the bid price.) You use the bid price to determine how much counter currency you can buy per one unit of base currency.
The ask price is the price you pay for the base currency. (The dealer “asks,” or sells, the base currency at this price.) You use the ask price to determine how much counter currency you need to purchase one unit of base currency.
In forex, the bid price always comes in under the ask price. And when it comes to your profits, tighter spreads make for better outcomes.
Another important set of conventions in forex currency trading is the idea of lots and pips. This can feel confusing, so we’re only going to touch on these concepts briefly.
What are forex lots?
Forex pairs are traded in lots, with each lot representing a certain amount of money to be traded. The size of the lot also dictates the type of forex account you use:
As your lot size grows, you take on more risk – as a rule, retail investors should steer clear of standard lots. Beginners should stick to micro lots as you learn the ropes. (Or better yet, with a forex broker’s demo trading account.)
What are forex pips?
You might be familiar with the concept that one point equals $1 in the world of stock market pricing (or points changes in an index like the Dow). In forex, you don’t have points – you have pips instead. But unlike the points system, the value of a pip depends on each trade’s lot and currency pair.
In simple terms, a pip is the smallest price movement that occurs in a currency pair. For instance, if you’re trading a pair that uses USD as its counter currency:
But if the USD is the base currency instead, the pip value will be based on the counter currency.
It’s not uncommon for investors to rely on leverage in the forex market. Leverage involves using borrowed money to make forex trades. If your trade nets a profit, relying on leverage can greatly magnify your returns. But if the trade goes sour, you might lose your shirt.
Forex trades primarily occur three ways:
The spot market is where currency pairs are actually traded based on real-time exchange rates.
In a spot deal, two parties agree to sell a set currency to the other at a specific exchange rate. Spot settlements always occur in case, though currencies vary.
The spot market is the largest of the three markets because its trades underlie the forwards and futures markets.
In forex futures markets, two traders enter into a standardized contract to buy or sell specific currencies at a future date and exchange rate. Forex futures trade on exchanges, rather than OTC, and tend to be popular with businesses and financial firms that want to hedge future price risks.
In forex forwards markets, two traders enter into a binding private contract to buy or sell specific currencies at a later date and exchange rate. Unlike futures, forwards contracts don’t trade on exchanges, instead occurring in OTC markets.
While you may be most familiar with exchanging currencies on international travels, most forex trades are made to seek profits or hedge bets. Forex traders can use a variety of strategies to increase their odds of success.
The first strategy is choosing the right trading pair. There are four types of currency pairs in forex:
It’s important to choose a pair that you think will see one currency significantly outperform the other on your given timeframe.
For instance, if you think geopolitical unrest will spike the USD compared to the JPY, you could buy the USD/JPY pair. If your prediction pans out, you’ll make a profit – but if JPY rises instead, you’ll lose money.
As with stock investing, you’ll also have to decide between going long or short.
In a long trade, you’re betting that a currency will increase in the future and you can profit from buying it. But in a short trade, you’re betting that a currency’s price will decrease, meaning you can profit by betting against it.
Forex traders can be classified by how quickly they trade:
Trend traders rely on technical indicators – like moving averages – to establish market momentum. Trend methods can help traders identify and profit from medium- to long-term bullish, bearish, or sideways trends.
When you think a trading pair’s price momentum will reverse, you might trade on this assumption to hopefully score profits.
In range trading, you identify a minimum and maximum value that a currency trades at in a set time frame. You might go long or short based on the given currency’s market price, trading range and overall volatility.
How do investors make their fortunes (or not) in the forex market? It all comes down to knowing when to buy and sell currency in forex trading.
Unfortunately, as with all investments, there’s no hard-and-fast rule to determine when to make your move. The forex market is volatile and there’s no guarantee that a trading pair will lose momentum at any given point.
What we can say is that knowing when to buy and sell currencies depends on your trading strategy, prices and potential profits. And in general, traders often agree that the best time of day to trade is when liquidity and volatility are high.
Forex trading is a risky business with plenty of opportunities to win and lose. As a rule, financial advisors tend to recommend that retail investors avoid actively trading forex, particularly in retirement accounts.
But if you have a solid portfolio beneath you, can afford the risks and know what you’re doing, forex can be lucrative…if you make the right bet.
Most traders generally trade forex for one of two reasons: to hedge against financial risks or speculate on price swings.
International businesses often use forex to hedge against currency fluctuations to prevent losses. This generally occurs in the futures market where firms can “fix” prices by locking in long-term exchange rates.
For instance, say that a U.S. company makes chairs they intend to sell in Germany, which uses the euro. Each chair costs $50 to make and will sell for a competitively-priced $100. Because the EUR/USD exchange rate is currently 1:1, that leads to $50 in profit per chair.
Unfortunately, the dollar rises until the EUR/USD exchange rate is 0.75, which means it now costs $0.75 to buy 1 euro. Since each chair still costs $100 to make but now sells at just $75 after conversion ($100 x 0.75 = $75), the company will earn smaller profits.
Fortunately, the chair company can minimize future price fluctuation risks by purchasing a FX futures contract based on the current exchange rate. This locks in the company's profit margin, so they don’t need to worry about currency fluctuations.
Another way to make money in the forex market is through speculation – essentially, betting that the exchange rate between two currencies will shift in a particular direction over time. These shifts can occur due to factors like economic strength, geopolitical events and interest rate changes.
For instance, say that you think current inflation means that the USD will be less valuable than the euro in a year. In that case, you might buy the EUR/USD pair and wait for the exchange rate to shift to profit. But if you think that the dollar will outperform in a year, you might short the EUR/USD pair instead.
While trading forex might sound fun, the reality is that it’s an incredibly risky market where you can lose more than you’re worth. As such, the average investor – that’s probably you – shouldn’t wade in too far, if at all.
Aside from the steep learning curve, you’ll also face enormous volatility and be massively outclassed by larger institutional investors at every turn.
But that doesn’t mean you have to stick with dry, boring assets either.
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