Without knowing it, you’ve probably participated in the foreign exchange market before. Maybe you’ve ordered imported products like clothing or shoes – or more obviously, bought foreign currency while on vacation in another country.

These are some of the common reasons people exchange currencies. Today, however, forex trading includes actively exchanging foreign monies for the express purpose of speculating on price movements.

The origins of this practice aren’t clearly known, but there are a few theories we’ll explore later in this course. Regardless of its origins, forex is today one of the most liquid financial markets in the world.

Unlike other markets, forex trades take place in an open marketplace where currencies are bought and sold over the counter (OTC) instead of on a centralized exchange.

The term ‘forex trader’ may describe an individual trader on a retail platform; a bank trader utilizing their institutional platform; or hedgers, who may be either managing their own risk or outsourcing that function to a bank or money manager to manage it for them.

There are several reasons why people may want to trade forex, including:

• The liquidity of the FX market
• A wide variety of currencies to trade
• Differing levels of volatility
• Low transaction costs
• 24-hour trading, five days a week

Whether forex trading is a new concept to you, or you’re looking to build on to your existing knowledge, this course seeks to give you a solid foundation on this market.

The two sides to every forex market

One unique aspect of the forex market is the manner in which prices are quoted. Because currencies are the base of the financial system, the only way to quote a currency is by using other currencies.

Trading currencies in a pair may need you to research the economic state of the two countries whose currencies you want to speculate on.

For example, let’s say you have optimistic projections for the European economy and would thusly like to go long on the euro. Say you also thought the US dollar will devalue because your research had shown a possible downturn in the country’s economy – so you may want to ‘sell’ it.

In this scenario, you might want to take a long position on the euro against the US dollar (which would be a long EUR/USD trade). If your analysis proves true, you’d realize a profit. However, you’ll make a loss if the US dollar doesn’t depreciate against the euro at all (because you’ll pay fees on your trade) or if it appreciates instead.

Let’s use a short exercise to test your understanding.

As you’ve seen from the exercise above, trading currencies in pairs affords you an extra bit of flexibility, enabling you to try and capitalize on both the euro and dollar’s appreciating values.

Instead of trading EUR/USD, you could buy the euro while going short the British pound, and/or sell the pound to buy US dollars.

Base versus quote currencies

One important distinction of a forex quote is the convention. The first currency listed in the pair is known as the ‘base’ currency of the pair. The ‘quote’ currency is the second in the pair, and it determines how much you’re paying for one unit of the base currency.

Let’s take EUR/USD as an example. The euro comes first in the quote, so it’d be the base currency in the pair.

EUR/USD

The second one after the forward slash is known as the quote (or counter) currency. It’s the currency that’s being used to outline the value of the first one.

EUR/USD

As mentioned, the US dollar is the currency that the quote is using to define the value of the euro. Not clear yet?

Let’s explore it further.

Say the EUR/USD price is 1.3000. That’d mean that €1 is worth $1.30, or that you’d need $1.30 to buy €1.

If the pair’s price moves up to $1.35, then the euro would have increased in value and, on a relative basis, the US dollar would’ve decreased in value.

Supply and demand in forex markets

Forex works like many other markets in that it’s driven by supply and demand. Using a very basic example, if there’s a strong demand for the US dollar from European citizens holding euros, they’ll exchange their euros into dollars, and the value of the dollar will rise while the value of the euro will likely fall.

Keep in mind that this transaction only affects EUR/USD and won’t, for example, cause the USD to depreciate against the Japanese yen.

In reality, the above example is only one of many factors that can move the FX market. Others include broad macro-economic events, like major elections; or country-specific factors such as the prevailing interest rate, GDP, unemployment, inflation and the debt-to-GDP ratio, to name a few.

You may remember from the previous course that experienced traders use resources like economic calendars to stay up-to-date with these and other important economic releases.

On a longer-term basis, one major driver of forex prices is interest rates. These can have a direct impact on holding a currency either long or short because any change in a country’s interest rate will likely change its money’s value. We’ll delve deeper into this concept later in the course.

The ‘core’ of the FX market is what’s known as the ‘interbank market’, which is where liquidity providers trade amongst each other.

The benefit of having trades between global banks and liquidity providers is that forex can be traded around the clock (during the week).

As the trading session in Asia ends, the European and UK banks come online before handing over to the US. The full trading day ends when the US session leads into the Asian session for the following day.

This makes the market even more attractive to traders as round-the-clock liquidity is often available. This means you can easily enter and exit positions most of the time as there are usually many willing buyers and sellers.

Who are the major players?

There are essentially two types of traders in the foreign exchange market: hedgers and speculators.

Hedgers are market participants that look to avoid extreme movements in the exchange rate. Think of big conglomerates that have overseas business interests, like Exxon, or people who invest in international securities. How could they look to reduce their currency risk (ie their exposure to foreign currency movements)?

Currency risk arises from potential changes in two currencies’ exchange rates, which could affect the value of foreign investments or the profits from international sales and/or the cost of purchases.

Companies – and sometimes, advanced traders – often hedge their exposure to foreign monies using forward exchange contracts (FECs), currency futures or options.

Currency futures are some of the more popular kinds of derivative instruments used for hedging currencies. These contracts detail the price at which a currency can be bought or sold and sets a specific date for the exchange.

Futures are highly regulated, and any counterparty still holding the contract at the expiration date is legally bound to take delivery of the currency on the given date and at the given price.

FECs work by enabling you to lock in an exchange rate in the present to sell it at a predetermined date in the future.

Simply put, FECs can give you the ability to exchange a currency at the current price at a later time when prices may have shifted.

Options work similarly but with some differences. These are financial contracts that give you the right, but not the obligation, to exchange currencies at a predetermined price, before or on the date of expiry.

You can either buy a call option, which can protect you from a rally in a currency pair; or a put option, which can protect you from a currency’s decline.

Speculators, on the other hand, are normally risk-seeking as they look to take advantage of fluctuations in currency exchange rates. This includes large trading desks at big banks as well as retail traders.

These market participants usually spend short amounts of time in a market because their main objective is to get in and out quickly to try and profit from small movements in exchange rates (or sometime large ones, in the case of major market-moving announcements).