Key points
- Forex traders make bets on fluctuations in global currency prices.
- Trades can use leverage and margin to make big profits on relatively small positions.
- These markets are volatile and unpredictable, so risk management is critical.
Most international travelers have experienced the process of exchanging their native currency for the local currency of their destination.
There are dozens of different fiat currencies around the world. Exchange rates among these currencies always fluctuate due to several factors, including supply and demand dynamics, changes in local economic conditions and the credibility of the governments backing the currencies.
Foreign exchange, or forex, traders speculate on changing exchange rates by converting large sums of money from currency to currency, much like stock traders buy and sell different stocks. Forex traders essentially attempt to buy low and sell high for a profit, but the asset they are trading is currency.
What is forex trading and how does it work?
The foreign exchange market is a global marketplace that operates 24 hours a day, including most U.S. holidays. Forex trading is conducted over the counter, meaning there is no physical exchange of assets.
Rather than using a central exchange, such as the New York Stock Exchange, the forex market is operated and monitored by a global network of banks and financial institutions.
Forex traders trade a currency pair, a quotation of two different currencies paired together. A currency pair essentially tells traders the current market value of one currency relative to another. Each currency in a pair is denoted by a three-letter code. These codes are typically two letters representing the region where the currency comes from and one letter representing the name of the currency itself. For example, the currency code for the U.S. dollar is USD, and the code for the British pound is GBP.
The first currency listed in the currency pair quote is called the base currency, and the second currency is the quote currency. The quote itself is a ratio of how much of the quote currency the trader can purchase one unit of the base currency. If the quote for a EUR/USD pair is 1.06, it means 1 euro (EUR) is worth $1.06 (USD).
How can you trade in the forex market?
You can start forex trading by opening an online trading account with a top forex broker, such as Interactive Brokers, TD Ameritrade or Ally Invest. Many leading online forex brokers also offer free demo accounts, where new users can get a feel for trading without putting their real money at stake.
There are dozens of different currency pairs in the forex market, but the seven major currency pairs make up about 75% of all trading in the forex market, according to CMC Markets.
The seven major currencies include the U.S. dollar, euro, Japanese yen (JPY), British pound (GBP), Australian dollar (AUD), Canadian dollar (CAD), Swiss franc (CHF) and New Zealand dollar (NZD).
The following seven pairings are considered the major currency pairs:
- EUR/USD.
- USD/JPY.
- GBP/USD.
- AUD/USD.
- USD/CAD.
- USD/CHF.
- NZD/USD.
In addition to the major pairings, there are a few other pairing categories:
- Minor pairs: Major currencies paired against each other, rather than against the U.S. dollar, such as pairing the euro against the British pound. Example: EUR/GBP.
- Exotic pairs: A major currency paired against a currency from a smaller or emerging market economy, such as pairing the British pound with the Mexican peso (MXN). Example: GBP/MXN.
- Regional pairs: Currency pairs from a specific region of the world, such as the pairing of the New Zealand dollar with the Australian dollar. Example: AUD/NZD.
The most advanced online forex trading platforms feature more than 100 different forex currency pairs.
Forex terms to know
Forex trading comes with a unique lexicon of terms, but it also shares common terminology with stock trading. To understand the art of forex trading, you must first learn the local language.
Ask: The ask price is the minimum price a currency seller is willing to accept to complete a trade.
Bid: The bid price is the maximum price a currency buyer is willing to pay to complete a trade.
Contract for difference: A contract for difference, or CFD, is a contract that pays the differences in the settlement price between the opening and closing of a trade and allows forex traders to speculate on currency prices without owning the underlying currencies.
Leverage: Leverage allows traders to control large trade sizes with relatively limited capital by trading on margin or by trading leveraged derivatives.
Lot size: A lot is a standardized unit of currency used in forex trading. The typical lot size is 100,000 currency units. A mini forex lot is worth 10,000 currency units. For example, with a mini forex lot, you would need 10,600 units of USD to buy 10,000 units of EUR.
Pip: A pip is an acronym for percentage in points and represents the smallest possible fluctuation. In most cases, a pip refers to the fourth decimal point of the price, usually 0.0001.
Spread: The spread is the difference between the ask price and the bid price for a given currency.
Pros and cons of forex trading
In the wide world of investing, there are numerous avenues you can take, each with its own unique set of advantages and challenges. One path some investors choose to tread is the fast-paced, ever-active arena of forex trading. It’s like the New York City of investing — the market that never sleeps
Like any investment strategy, forex trading is not without risks and rewards.
Forex trading may not be as common as stock trading, but there are several key advantages to forex trading.
For one, the forex market is extremely liquid. That makes it easy for traders to quickly enter and exit positions. Forex trading also offers investors opportunities to utilize leverage to generate large profits with a relatively small amount of capital.
But leverage is a two-way street for forex traders, says Gabriel Lalonde, certified financial planner and president of MDL Financial Group.
“Forex trading can also be highly volatile and unpredictable, with sudden market shifts and economic events causing significant price movements. This can lead to higher levels of risk, requiring traders to manage their positions and employ risk management strategies carefully,” Lalonde says.
The global forex market was $753.2 billion in 2022, according to The International Market Analysis Research and Consulting Group. The market research group anticipates that the global foreign exchange market will continue to grow each year, reaching more than $1 trillion in size by 2028.
“The rising consumer awareness towards the numerous benefits of foreign exchange, such as minimal trading costs, high liquidity and transactional transparency, 24×7 trading opportunities, etc., is primarily driving the global foreign exchange market,” IMARCI states on its website.
Because of the opportunities to utilize leverage, new forex traders don’t need much money upfront to begin trading. But trading commissions and margin fees can eat into forex trading profits.
Investors should also note that, unlike stocks or bonds, currencies don’t generate cash flow or profits or pay dividends.
Forex markets are open 24 hours a day. So naturally, the hours provide more trading opportunities for investors than the stock and bond markets. The drawback means traders must be careful to manage risk if they plan to leave positions open while they sleep or do other activities.
Pros and cons of forex trading
| PROS | CONS |
|---|---|
Large and liquid market. | Leverage trading increases risk. |
More than 100 global currency pairings. | Unpredictable geopolitical headlines. |
Open 24 hours, five days a week. | Trading commissions and margin fees. |
Low initial capital requirements. | Open trades require 24-hour risk management. |
High volatility creates profit-making opportunities. | Currencies don’t generate cash flow or dividends. |
Types of forex trades
Scale trades
Scale trading is a forex trading strategy that involves starting with a small initial position and then scaling into a larger position gradually over time. Scale trading helps reduce risk because losses are minimal if the initial trade fails out of the gate.
Day trades
Forex day trading involves entering and exiting positions within the same day. Day traders attempt to profit off short-term currency fluctuations that occur over a matter of hours or minutes.
Swing trades
Forex swing trading involves trading currencies over a medium-term time frame ranging from a few days to several weeks. Swing traders focus on time frames that are longer than short-term day trades and shorter than long-term position trades.
Position trades
Forex position trading involves buying a currency that you believe will rise in price over a period of months or years and looking for a relatively large gain on the position. Position traders don’t typically pay attention to day-to-day forex market volatility and instead focus on fundamental analysis of the markets and economies they are targeting.
How to start trading forex
Feeling ready to dive into forex trading? Follow these few simple tips before getting your feet wet.
1. Research forex.
To minimize costly mistakes, make sure you understand the basics of forex trading before you make your first trade. Trading platforms generally provide users with free educational materials on their sites. You can take course and self-assem*nt quizzes on forex.com, to name one example.
2. Use a brokerage account that allows forex trading.
Not every online broker allows forex trading, and different brokers have different fee structures, currency pairs, and account restrictions.
Popular forex trading platforms include Ally Invest, eToro, Interactive Brokers and TD Ameritrade, to name a few. If you’re looking at using margin for trades, you’ll also want to screen the list of brokers that offer forex trading with the more advantageous margin rates, for instance.
3. Leave emotions at the door.
All new traders should remember simple, common-sense tips to minimize financial risk. Stay disciplined, make rational trades rather than emotional decisions and never open a position with more money than you are willing to lose.
4. Monitor your position.
Remember that forex markets are open 24 hours and can be extremely volatile and exposed to geopolitical headline risk. A winning trade can turn into a complete disaster in a matter of minutes, and it may happen at 3 a.m.
Frequently asked questions (FAQs)
There’s no one-size-fits-all strategy in forex trading. The best strategy for you largely depends on your goals, risk tolerance and time commitment.
Some traders prefer day trading, where positions are opened and closed within a single day to capitalize on short-term market fluctuations. Others might opt for swing trading or position trading, which involve holding positions for days, weeks or even months.
Regardless of your chosen strategy, effective risk management, a solid understanding of the forex market, and continuous learning and adaptation are all critical components of successful forex trading.
Forex trading can indeed be profitable. The foreign exchange market’s liquidity and volatility, as well as the ability to utilize leverage, provide opportunities for savvy traders to make substantial profits.
But it’s essential to remember that the same factors also increase risk, and losses can be significant. Profitability in forex trading is not guaranteed, and success often depends on a combination of skill, knowledge, strategy and risk management.
Forex trading is relatively straightforward for new traders, but only if they fully understand the risks involved in trading on margin and utilizing leveraged positions. Any new trader should consider starting small to minimize the potential for large losses.
There is no centralized global forex governing body, but several countries around the world have their own independent forex regulators.
In the U.S., the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) regulate the forex market. In the U.K., the Financial Conduct Authority (FCA) regulates forex markets. And for Canada, it’s the Investment Industry Regulatory Organization of Canada (IIROC).
