What is forex trading?

Forex trading is the conversion of currencies into one another. It’s the largest financial market in the world – and one of the most volatile. 

What is foreign exchange?

Foreign exchange, or forex, is the means by which individuals, companies and central banks convert one currency into another. While a lot of foreign exchange is done for practical purposes, the vast majority of currency conversion is undertaken with the aim of earning a profit.

The amount of currency converted everyday – over $5 trillion dollars’ worth – makes forex trading the biggest financial market in the world and can make some currency’s price movements extremely volatile. That volatility is part of why forex is so attractive to some traders: bringing about greater chance of high profits, while also increasing risk.

Why trade forex?

There are many reasons why someone might want or need to participate in the forex market. However, two key activities make up the majority of forex trades.

1. Buying goods or services abroad

This is the form of forex trading that most people are familiar with. Whenever an individual or a business needs to buy something in a different currency, a forex trade must be made. So for practises like international trade, forex is essential.

While forex trades for practical purposes happen every second of every day, they make up a relatively small proportion of all currency trading.

2. Speculation

Instead, most forex trades are undertaken with the aim of making money. Traders speculating on forex prices will not plan to take delivery of the currency itself, instead aiming to take advantage of movements in the market.

Major investors can make many large forex trades in a single day, constantly reacting to and anticipating movements in a currency’s price. The relative ease with which currency can be traded makes it a very liquid asset, which is partly why forex can be more volatile than other markets.

Who trades forex?

The biggest forex traders on the market are big international banks like Citigroup, UBS and Barclays, aiming to make a profit by taking advantages of price movements in the market. Between them, the biggest four banks trading forex make up around 50% of all forex trading. However, a huge number of individual traders also participate in the market.

Central banks and governments also trade forex in order to control the supply of currency in their economy. And consumers, businesses and financial institutions all exchange currency when trading overseas, travelling abroad or investing in foreign markets.

What moves forex markets?

Like most financial markets, forex price movement is primarily driven by supply and demand.

Banks and other investors tend to want to put their capital into economies that have a strong outlook. So if a positive piece of news hits the markets about a certain region, it will encourage investment and increase demand for that region’s currency.

Unless there is a parallel increase in supply for the currency, the disparity between supply and demand will cause its price to increase. Similarly, a piece of negative news can cause investment to decrease, in turn lowering a currency’s price. For this reason, currencies tend to reflect the economic health of the region they represent.

There are several events that can affect the demand levels of a currency, including:

  • Interest rate decisions
  • Inflation announcements
  • GDP reports

Market sentiment can also play a major role in driving currency prices. If traders believe that a currency is headed in a certain direction, they will trade accordingly and may convince others to follow suit, increasing or decreasing demand accordingly.

But demand isn’t the only variable that can impact a currency’s price. Supply is controlled by central banks, who can announce measures that will have a significant effect on their currency’s price. Quantitative easing, for instance, involves injecting more money into an economy, and can as such cause its currency’s price to drop. 

Where do you trade forex?

Unlike shares or commodities, forex trading does not take place on exchanges. Instead, currencies are exchanged directly between two parties, in what is called an over-the-counter (OTC) market.

What that means in principle is that the forex market is run across a global network of banks, spread across four major forex trading centres in different time zones: London, New York, Sydney and Tokyo. And with no central location that trades have to go through, you can trade forex 24-hours a day.

In order to trade forex, you’ll need a forex broker. Alternatively, you can take advantage of forex movement using derivatives like CFDs or digital 100s.

Find out how forex trading works

For more detail on the mechanics of a forex trade – including major and minor pairs, pips and leverage – take a look at how forex trading works.

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