All trading involves risk. Losses can exceed deposits.

What is forex?

Forex (also known as FX) is the short form of foreign exchange, which quite simply refers to the conversion of one currency into another. Forex is the largest financial market in the world – and one of the most volatile.

All trading involves risk. Losses can exceed deposits.

Forex explained

Forex, or foreign exchange, 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 – makes forex trading the biggest financial market in the world and can make price movements of some currencies 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 the risk.

What is a currency exchange rate?

The currency exchange rate is the rate at which one currency can be exchanged for another. It is quoted in pairs such as GBP/USD (the British pound and the US dollar). A currency exchange rate is either floating – ie changing from day to day – or pegged at a fixed rate. For example, the Qatari riyal is pegged to the US dollar at a fixed exchange rate of $1/3.64 QR.

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.

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

 

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.

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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.

Factors that can affect currency demand

There are many factors that can affect the demand levels of a currency over either a short-, medium- or longer-term timeframe.

Short-term considerations Risk appetite, volatility, moves in commodity prices, interest rate pricing and positioning
Medium-term considerations Current account surplus/deficit, fiscal policy, political risk, bond yield spreads (or differentials) and relative economic growth
Longer-term considerations Purchasing power parity, net foreign assets and terms of trade

 

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 spread betting, CFD trading or digital 100s.

The different types of forex market

There are three different types of forex market: spot, forward, and future.

Spot

The spot forex market is where two parties agree to buy one currency against the sale of another at the current market price.

With spot forex there is a physical exchange of the currency pair, which takes place at the exact point the trade is settled – ie ‘on the spot’ – or within a short period of time thereafter.

Forward

The forward forex market is where a contract is made to buy or sell a set amount of a currency at a specified price, but it’s either settled at a predetermined future date, or within a range of future dates.

Forward contracts can be used to lock in a currency rate in anticipation of its increase at some point in the future.

Future

The future forex market is where a contract is made to buy or sell an amount of a given currency at a predetermined price, at a set date in the future.

The future market is very similar to the forward market, except that all futures contracts are legally binding and contain a specific termination date, at which point the currency must be exchanged. 

Classifications of currency pairs 

Theoretically you can exchange any currency in the world for any other currency, which means the variety of forex pairs you could potentially trade is vast.

Major pairs

In practice, the majority of forex trades take place on a few select currency pairs called the majors. What constitutes a major pair varies widely depending on who you speak to, but most include the following six which account for over 80% of global forex trade:

Currency pair Currency names
EUR/USD Euro/US dollar
USD/JPY US dollar/Japanese yen
GBP/USD Sterling/US dollar
USD/CHF US dollar/Swiss franc
USD/CAD US dollar/Canadian dollar
AUD/USD Australian dollar/US dollar

 

All of these pairs include the US dollar, which is by far the single most traded currency in the world.

Minor and exotic pairs

Pairs which are traded less frequently are known as minor currency pairs. You may also see them referred to as cross-currency pairs or simply crosses, particularly if the US dollar isn't involved. The most popular minor pairs tend to contain the euro (EUR), sterling (GBP) or the Japanese yen (JPY).

Some forex brokers may also refer to exotic or emerging pairs. These generally consist of one major currency against another from a small or emerging economy, for example GBP/MXN (sterling vs Mexican peso) or USD/PLN (US dollar vs Polish zloty).

Regional pairs

You may also come across forex classes which are based on a region, such as Australasian pairs or Scandinavian pairs. These classes set currencies from their respective regions against one another, or pair them with others from around the world. For example AUD/NZD (Australian dollar vs New Zealand dollar) could be categorised as an Australasian pair, while EUR/NOK (euro vs Norwegian krona) would be a Scandinavian pair.

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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