What is forex and how does it work?
Forex, also known as foreign exchange or FX trading, is the conversion of one currency into another. Take a closer look at everything you’ll need to know about forex trading, including what it is, how it works and the ways that you can trade forex with IG.
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What is forex trading?
Forex trading is the means through which one currency is changed into another. When trading forex, you are always trading a currency pair – selling one currency while simultaneously buying another.
Each currency in the pair is listed as a three-letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself. For example, USD stands for the US dollar and JPY for the Japanese yen. In the USD/JPY pair, you are buying the US dollar by selling the Japanese yen.
Some of the most frequently traded FX pairs are the euro versus the US dollar (EUR/USD), the British pound against the euro (GBP/EUR), and the British pound versus the US dollar (GBP/USD).
To keep things ordered, most providers split pairs into the following categories:
- Major pairs - seven currencies that make up 80% of global forex trading. Includes EUR/USD, USD/JPY, GBP/USD and USD/CHF
- Minor pairs - less frequently traded, these often feature major currencies against each other instead of the US dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
- Exotics - a major currency against one from a small or emerging economy. Includes: USD/PLN, GBP/MXN, EUR/CZK
- Regional pairs - pairs classified by region – such as Scandinavia or Australasia. Includes: EUR/NOK, AUD/NZD, AUG/SGD
Most forex transactions are carried out by banks or individuals by seeking to buy a currency that will increase in value against the currency they sell. However, if you have ever converted one currency into another, for example when traveling, you have made a forex transaction.
How does forex trading work?
Forex trading takes place directly between two parties in an over-the-counter (OTC) market. This means that forex trading is conducted without a centralized exchange, and the forex market is instead run by a global network of banks and other organizations.
Transactions are spread across four major forex trading centers in different time zones: London, New York, Sydney and Tokyo. Since there is no centralized location, you can trade forex 24 hours a day.
Most traders speculating on forex prices will not plan to take delivery of the currency itself; instead they make exchange rate predictions to take advantage of price movements in the market. The most popular way of doing this is by trading derivatives.
Trading derivatives allows you to speculate on an asset’s price movements without taking ownership of that asset. For instance, with spot forex trading you can make a prediction on the direction in which you think a forex currency pair’s price will move. The extent to which your prediction is correct determines your profit or loss.
The three different types of forex market:
There are three different ways to trade on the forex market: spot, forward, and future.
- Spot forex market: the physical exchange of a currency pair, which takes place at the exact point the trade is settled – ie ‘on the spot’ – or within a short period of time
- Forward forex market: a contract is agreed to buy or sell a set amount of a currency at a specified price, to be settled at a set date in the future or within a range of future dates
- Future forex market: a contract is agreed to buy or sell a set amount of a given currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding
Forex pricing – base and quote currency
The first currency listed in a forex pair is called the base currency, and the second currency is called the quote currency. The price of a forex pair is how much one unit of the base currency is worth in the quote currency.
In the above example, GBP is the base currency and USD is the quote currency. If GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.
If the pound rises against the dollar, then a single pound will be worth more dollars and the pair’s price will increase. If it drops, the pair’s price will decrease. So, if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (going long). If you think it will weaken, you can sell the pair (going short).
What is leverage in forex trading?
A key advantage of spot forex is the ability to open a position on leverage. Leverage allows you to increase your exposure to a financial market without having to commit as much capital.
When trading with leverage, you don’t need to pay the full value of your trade upfront. Instead, you put down a small deposit, known as margin. When you close a leveraged position, your profit or loss is based on the full size of the trade.
This means that leverage can magnify your profits, but it also brings the risk of amplified losses – including losses that can exceed your initial deposit. Leveraged trading therefore makes it extremely important to learn how to manage your risk.
What is margin in forex trading?
Margin is a key part of leveraged trading. It is the term used to describe the initial deposit you put up to open and maintain a leveraged position. When you are trading forex with margin, remember that your margin requirement will change depending on your broker, and how large your trade size is.
Margin is usually expressed as a percentage of the full position. So, a trade on EUR/USD, for instance, might only require a deposit of 2% of the total value of the position for it to be opened. This means that while you are still risking $10,000, you’d only need to deposit $200 to get the full exposure.
What is a pip in forex trading?
Pips are the units used to measure movement in a forex pair. A forex pip usually refers to a movement in the fourth decimal place of a currency pair. So, if EUR/USD moves from $1.35361 to $1.35471, then it has moved a single pip. The decimal places shown after the pip are called micro pips, or sometimes pipettes, and represent a fraction of a pip.
The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip. So, if EUR/JPY moves from ¥172.119 to ¥172.129, it has moved a single pip.
What is the spread in forex trading?
In forex trading, the spread is the difference between the buy and sell prices quoted for a forex pair. If, for instance, the buy price on EUR/USD was 1.7645 and the sell price was 1.7649, the spread would be four pips.
If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.
IG offers competitive spreads of 0.8 pips for EUR/USD and USD/JPY, and 1 pip on GBP/USD, AUD/USD and EUR/GBP.
What is a lot in forex trading?
Currencies are traded in lots – batches of currency used to standardise forex trades. In forex trading, a standard lot is 100,000 units of currency. Alternatively, you can sometimes trade mini lots and micro lots, worth 10,000 and 1000 units respectively.
Individual traders don’t necessarily have 100,000 dollars, pounds or euros to place on every trade, so many forex trading providers offer leveraged
What moves the forex market?
Like most financial markets, forex is primarily driven by the forces of supply and demand, and it is important to gain an understanding of the influences that drive these factors.
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 cause its currency’s price to drop.
Central banks also control the base interest rate for an economy.
If you purchase an asset in a currency that has a high interest rate, you may get higher returns. This can make investors flock to a country that has recently raised interest rates, in turn boosting its economy and driving up its currency.
However, higher interest rates can also make borrowing money harder. If money is more expensive to borrow, investing is harder, and currencies may weaken.
Commercial 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 and lower a currency’s price. As a result, currencies tend to reflect the reported economic health of the country or region that they represent.
Take a look at our economic calendar to see what’s ahead, and pay particular attention to:
- Inflation figures
- Production reports
- Retail sales
Market sentiment, which is often in reaction to the news, 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.
You can see sentiment from IG clients – as well as live prices and fundamentals – on our market data pages for each market.
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