What is forex trading and how does it work?
If you’re exploring how to trade currencies, this guide explains what forex trading is, how it works in practice, what moves exchange rates, and the risks you need to understand before getting started.
What is forex trading?
Forex trading, also known as foreign exchange trading, is the process of exchanging one currency for another in the hope of making a profit from price movements.
It involves buying and selling currencies to profit from changes in exchange rates. The largest and most liquid financial market in the world, it's also one of the most complex, especially when leverage is involved.
Unlike investing in shares, where you own part of a company, forex trading is based on relative value. You’re always comparing two currencies. If one strengthens while the other weakens, the price of the pair moves.
For example, if you believe the euro will rise against the US dollar, you might buy the EUR/USD pair. If the price increases, you could make a profit. If it falls, you could make a loss.
For those looking to learn how to trade, forex is often one of the first markets encountered because of its accessibility and round-the-clock trading hours.
How the forex market works
The forex market operates differently from traditional stock exchanges. It is a decentralised, over-the-counter (OTC) market, meaning there is no single exchange where all transactions take place.
Instead, trading happens electronically between participants including banks, institutions, corporations and individual traders.
One of the defining features of forex is its 24-hour trading cycle during the week. Activity moves between major financial centres:
- London
- New York
- Tokyo
- Sydney
This continuous flow means prices can react quickly to global events, often outside traditional market hours.
Because of its scale, the forex market is highly liquid. Large volumes can be traded with relatively small price impact, particularly in major currency pairs.
Currency pairs explained
Currencies are always traded in pairs because you are simultaneously buying one and selling another.
Each pair has two components:
- Base currency – the first currency listed
- Quote currency – the second currency listed
For example, in GBP/USD:
- GBP is the base currency
- USD is the quote currency
If GBP/USD rises from 1.25 to 1.30, it means the pound has strengthened relative to the dollar.
Types of currency pairs
Forex pairs are often grouped into three categories:
Major pairs
These include the most traded currencies globally, such as EUR/USD, GBP/USD and USD/JPY. They tend to have high liquidity and tighter spreads.
Minor pairs
These exclude the US dollar but still involve major currencies, such as EUR/GBP.
Exotic pairs
These involve emerging market currencies and can be more volatile, with wider spreads. However, these can be more volatile, higher risk, and therefore may not be suitable for beginners. We suggest practicing on a demo account first, with virtual funds used in order to remove the risk element until you do enter a live trading environment.
What drives forex prices?
Understanding what moves currency markets is central to trading forex effectively.
Interest rates and central banks
Interest rate decisions by central banks, such as the Bank of England or the Federal Reserve, are one of the biggest drivers of currency movements. Higher interest rates can attract foreign capital, strengthening a currency.
Economic data
Indicators such as inflation, employment figures and GDP growth can influence how investors view an economy.
Political and geopolitical events
Elections, policy changes and global tensions can affect confidence in a currency.
Market sentiment
Currencies are also influenced by broader investor behaviour, such as risk appetite. For example, during periods of uncertainty, traders may favour perceived “safe haven” currencies.
This is where fundamental analysis plays a role. Even if you rely primarily on charts, understanding these drivers helps explain why markets move.
How forex trading works in practice
In practical terms, forex trading involves analysing the market, choosing a position and managing risk.
Many traders use a combination of chart analysis and economic context. Tools such as technical indicators can help identify trends or potential entry points.
Going long and short
Forex trading allows you to take positions in either direction:
- Going long means buying a pair expecting it to rise
- Going short means selling a pair expecting it to fall
This flexibility is one of the reasons forex trading is popular, but it also means you are exposed to risk in both directions.
Leverage in forex trading
Forex is commonly traded using leverage, particularly through derivatives such as CFDs.
Leverage allows you to control a larger position with a smaller deposit, known as margin. While this can increase potential returns, it also increases the size of potential losses, as you stand to lose your entire deposit if the market moves against you.
When trading forex with leverage, you’re controlling a larger position than your initial deposit.
For example, let’s say you want to trade the GBP/USD currency pair with a position size of £10,000. Without leverage, you would need to commit the full £10,000 to open the trade.
However, if the margin requirement is 5%, you would only need £500 to open that same £10,000 position. While this lowers the upfront cost, your profit and loss are still calculated on the full £10,000 exposure.
If you go long on GBP/USD and the exchange rate rises by 2%, your position would increase in value by £200. That represents a 40% return on your initial £500 margin.
But the reverse is also true. If the market moves against you and GBP/USD falls by 2%, you would lose £200. A larger move could result in losses that approach or exceed your initial deposit, depending on how the position is managed.
This is why leverage can amplify both gains and losses, and why careful risk management is essential when trading forex.
You can explore the concept further in our article on what CFD trading is and how it works.
Key Takeaway
Forex trading offers flexibility and access to global markets, but it requires a clear understanding of how currency pairs move and how risk is managed, particularly when using leverage.
Forex trading vs other markets
Forex trading differs from other markets in several ways.
| Feature | Forex | Shares | Indices |
| Trading hours | 24 hours (weekdays) | Exchange hours | Extended hours, often close to 24 hours |
| Liquidity | Very high | Varies | High |
| Leverage | Common | Limited (in investing) | Common |
| Drivers | Macro and economic | Company-specific | Economic data, corporate earnings and market sentiment |
Important to know
Because forex is heavily influenced by macroeconomic factors, it often requires a broader understanding of global markets compared to stock trading.
If you’re comparing markets, you may also want to explore indices trading.
Risks of forex trading
Forex trading carries significant risk, particularly for beginners.
Leverage, as discussed above, means that even small price movements can have a large impact on your account. Markets can also react unpredictably to news events, leading to rapid price changes.
Other risks include:
- Overtrading in highly liquid markets
- Misinterpreting economic data
- Holding positions during volatile periods
Because of these factors, forex trading may not be suitable for everyone. It’s important to understand how the market works and to use risk management tools where possible.
Quick fact
The global forex market sees average daily trading volumes exceeding $6 trillion, making it larger than all major stock markets combined.
How to start trading forex
If you’re looking to start trading forex, it helps to take a structured and measured approach rather than rushing straight into live markets. Begin by building a solid understanding of how currency pairs work, what drives exchange rates and how leverage affects both profits and losses. You can do this firstly by exploring our extensive Academy, with its training courses and webinars. Then, consider opening a demo account with us, offering access to virtual funds with which to practice and hone your forex trading craft.
As your confidence grows, you can start developing a trading approach that combines both technical analysis, such as chart patterns and indicators, and an awareness of key economic events that move currencies. When you transition to live trading, it’s generally sensible to begin with smaller position sizes and focus on managing risk carefully, as market movements can be unpredictable and losses can occur as well as gains.
Forex trading tips for beginners
Determine your risk per trade
The risk-per-trade method is a basic money management strategy in trading. It involves deciding how much of your trading account you're willing to risk on any single trade. In general, it's best not to risk more than 2-3% of your account on a trade.
This ensures you have enough money to handle a series of losses. It's better to risk small amounts and gradually increase your account, rather than risk too much and deplete your trading funds.
Don't overtrade
There's no need to make a trade every hour or even every day. Wait for a good trade setup and avoid chasing the market for trading opportunities. Patience and discipline are key to successful trading. Overtrading won't help, even with the best money management plan.
Cut your losses and let your profits run
Successful traders follow the rule of cutting losses quickly and letting profits run. They close losing positions early, but let winning positions continue. Beginners often do the opposite, holding onto losing positions hoping they will turn around, and closing profitable positions too early for fear of missing out. It's important to adopt the mindset of cutting losses and maximising profits.
Always use stop loss orders
Stop loss orders are vital for risk and money management and should be part of any trading money management plan. A stop loss order automatically closes your position when the price reaches a certain level, limiting potential losses. All trading money management strategies should include stop loss orders.
Aim for trades with a reward-to-risk ratio of at least 1
Studies have shown that traders who enter trades with a reward-to-risk ratio of 1 or higher tend to be more profitable. The ratio refers to the potential profits and losses of a trade. By only taking trades with a ratio higher than 1, you need fewer winning trades to break even.
Calculate your position size correctly
Many traders struggle with calculating their position size to maintain their defined risk-per-trade. Position sizes are crucial in money management as they determine a trade's potential profit. To calculate your position size accurately, take the total risk per position and divide it by the risk-per-trade. The result gives you the maximum value you can take to maintain your defined risk-per-trade.
For example, if your total risk is 1% of a £10,000 account, your risk-per-trade is £100. If you trade with a 10 pip stop loss, let's say buying GBP/USD at $1.2000 with a stop loss at $1.1990, your position size (how much you can buy or sell) is then £10 per pip ($1.2000-$1.1990 = $0.0010 or 10 pip risk; multiplied by £10 per pip spread bet = £100 risk-per-trade).
If your stop loss is at $1.1900, you'd be risking 100 pips and your position size would drop to £1 per pip ($1.2000-$1.1900 = $0.0100 or 100 pip risk; multiplied by £1 per pip spread bet = £100 risk-per-trade).
Be cautious with leverage
Trading with leverage can attract new traders to financial markets. However, leverage is a double-edged sword. It can increase profits, but it can also magnify losses. Be cautious and understand the risks when trading with leverage.
Avoid greed
Greed and fear can harm your trading decisions. With experience, you'll learn to manage your emotions so they don't affect your trading. It's important to be realistic about your goals. Avoid overtrading and setting unrealistic profit targets. A trade with a high risk and a low profit target is likely to result in a loss.
Use trailing stops to secure profit
An effective trading money management plan should include different types of stop loss orders for different market conditions. When a market is trending strongly, it might be wise to use a trailing stop set at the average height of the correction wave.
This allows you to secure profits as the trend continues, as the trailing stop will automatically adjust your stop loss.
Remember, successful trading requires discipline, patience, and a solid money management plan.
FAQs
What does forex (FX) trading mean?
Forex trading means exchanging one currency for another. Forex is always traded in pairs which means that you’re selling one to buy another.
Is there a difference between forex trading and currency trading?
There is no difference between forex trading and currency trading, as both mean that you’re exchanging one currency for another. When forex trading or currency trading, you’re attempting to earn a profit by speculating on whether the price of a currency pair will rise or fall.
How can I make money from forex trading?
You can make money from forex trading by correctly predicting a currency pair’s price movements and opening a position that stands to profit. For example, if you think that a pair will decline in value, you could go short and profit from a market falling.
Alternatively, if you think a pair will increase in value, you can go long and profit from an increasing market.
How can I get started trading FX?
You can get started trading FX with a forex trading account. Plus, you’ll also need to be familiar with what moves the forex market – like central bank announcements, news reports and market sentiment – and take steps to manage your risk accordingly.
What costs and fees do you have to pay when currency trading?
The costs and fees you pay when trading currency will vary from broker to broker. But, you should bear in mind that you’ll often be trading currency with leverage, which will reduce the initial amount of money that you’ll need to open a position. Be aware though that leverage can increase both your profits and your losses.
How much money is traded on the forex market daily?
Approximately $6.6 trillion worth of forex transactions take place daily, which is an average of $250 billion per hour. The market is largely made up of institutions, corporations, governments and currency speculators – speculation makes up roughly 90% of trading volume and a large majority of this is concentrated on the US dollar, euro and yen.
Is forex trading income taxable?
The tax on forex positions does depend on which financial product you are using to trade the markets.
When you trade via a forex broker or through CFDs, any gains to your forex positions are taxable. However, your losses are tax-deductible, and depending on your circumstances can also be used to offset gains made elsewhere.
Alternatively, spread bets are a tax-free way to speculate on the forex market.9
How is the forex market regulated?
Despite the enormous size of the forex market, there is very little regulation because there is no governing body to police it 24/7. Instead, there are several national trading bodies around the world who supervise domestic forex trading, as well as other markets, to ensure that all forex providers adhere to certain standards. For example, in the UK the regulatory body is the Financial Conduct Authority (FCA).
What are gaps in forex trading?
Gaps are points in a market when there is a sharp movement up or down with little or no trading in between, resulting in a ‘gap’ in the normal price pattern. Gaps do occur in the forex market, but they are significantly less common than in other markets because it is traded 24 hours a day, five days a week.
However, gapping can occur when economic data is released that comes as a surprise to markets, or when trading resumes after the weekend or a holiday. Although the forex market is closed to speculative trading over the weekend, the market is still open to central banks and related organisations. So, it is possible that the opening price on a Sunday evening will be different from the closing price on the previous Friday night – resulting in a gap.
Try these next
Take a look at our list of financial terms that can help you understand trading and the markets
Be aware of the risks associated with forex trading and understand how IG supports you in managing them
Discover the different platforms that you can trade forex with IG
1 Bank of International Settlements Triannual Survey, 2019
2 Calculated using figures from the IMF, 2019
3 Calculated using the initial contract value for 15 October 2008
4 Calculated using data from Coin Market Cap
5 Calculated using Office of National Statistics average weekly earnings from Q3 2020
6 Calculated using a Forbes estimate of Jeff Bezos’s net worth, October 2020
7 By number of primary relationships with FX traders (Investment Trends UK Leveraged Trading Report released July 2024).
8 Awarded UK’s best trading platform at the ADVFN International Financial Awards 2020 and Professional Trader Awards 2019.
9 Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
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