What is forex trading?
Summary: An abbreviation for Foreign Exchange, "forex" is the buying and selling of one currency in exchange for another.
What is forex?
Forex transactions are carried out by central and retail banks, corporations, hedge funds and individual investors. They take place in the foreign exchange market, which is the largest and most liquid market in the world, with daily trades amounting to trillions of dollars.
Forex is traded any time one currency is exchanged for another. This can happen on a large scale, when corporations do business with other corporations from abroad, or on a small scale, when an individual travels overseas and exchanges money at the airport for local spending.
What is forex trading?
With an array of currencies being traded every day, the exchange rate between currencies in the forex market fluctuates constantly.
In forex trading, retail traders aim to take advantage of this volatility in the forex market, and they participate in trading with the goal of turning a profit. Forex traders try to make market predictions with various tools and strategies, such as fundamental and technical analysis.
In this manner, forex trading is similar to stock trading. Stock traders aim to make profits based on stock market forecasts and fluctuations. They attempt to purchase a stock when it is undervalued and they predict its price will rise, and they sell a stock when it is valued higher and they predict its price will fall. Forex traders take a similar approach, purchasing a currency when they predict its exchange rate will rise, and vice versa.
Run by a global network of banks around the world, there is no central location for the foreign exchange market. Rather, the electronic marketplace is driven by four local sessions worldwide: Sydney, Tokyo, London, and New York. Each session runs from morning to evening five days a week — from Monday to Friday — following local time.
This means that each week, the Australian session begins first. This is followed by that of the Asian session in Tokyo a few hours later, then the European session in London, and finally the North American session in New York.
Traders around the world can participate in any session they wish. The forex market is closed on weekends to retail traders, but as each local session lasts for eight to nine hours a day, market hours inevitably overlap. This provides opportunities for trading 24 hours a day, for a little over five days a week.
Generally, traders stick to participating in their respective local sessions. This means that Singaporean forex traders who stick to typical hours tend to be most active during the Australasian sessions, and they contribute to the high volume of trades during this window alongside Australian and other Asian traders.
How forex trading works
Fundamentally, forex trading is the process of buying and selling currencies. Trading takes place in an over-the-counter market, directly between two parties who have agreed on a purchase price.
Retail traders speculate on the direction of currency market prices through forex analyses methodologies such as fundamental and technical analyses. When they see potential for one currency to decrease in value and another to increase at the same time, they exchange amounts of the first currency for the second one.
Retail traders aim to profit from fluctuating price movements.
What is a currency pair?
As forex trading involves exchanging one currency for another, currencies must come in twos, making up a currency pair.
In forex, currencies are sorted into two broad categories.
Major currencies are currencies derived from the most powerful economies around the world – the US, the UK, Japan, Canada, Australia, New Zealand, Switzerland, and the eurozone. All other countries are considered minor or exotic currencies.
Currencies are expressed as currency symbols, such as USD for the United States dollar, GBP for the Great British pound, SGD for the Singapore dollar, and so on. Currency pairs are represented by putting together two currency symbols. For example, the pairing of the Singapore dollar and the US dollar is expressed as SGDUSD.
Each currency pair consists of two parts: the base currency, which is the currency on the left (SGD), and the variable currency, the one on the right (USD).
A variable currency is also known as a quote currency.
When the base currency is strengthening against the variable currency, the currency pair moves up. When the reverse happens, the currency pair moves down.
The market price of the currency pair demonstrates the price of one unit of the quote currency relative to that of the base currency. For example, if SGDUSD has an exchange rate of 0.756, it means that it costs 0.756 US dollars to buy 1 Singapore dollar.
In forex trading, traders make decisions based on predictions of these price changes.
As a trade is an exchange where traders sell one currency to buy another, they must evaluate the market price of both currencies relative to each other.
For example, a forex trader sells his US dollars for Singapore dollars because they predict that the market value of the Singapore dollar will increase relative to the US dollar. In other words, they predict that the market value of the US dollar will decrease relative to the Singapore dollar.
What types of currency pairs are there?
There are three main types of currency pairs: major, minor, and exotic.
Major currency pairs are formed when the US dollar is paired with another major currency. They are the most traded currency pairs in the forex market and account for over 80% of daily trades.
Major currency pairs can be divided into two further categories.
The ‘traditional majors’ are the first four pairings: EURUSD, GBPUSD, USDJPY and USDCHF, and the ‘commodity pairs’ are the other three pairings: AUDUSD, USDCAD, and NZDUSD.
Some major currency pairs also have their own nicknames, commonly used by forex traders.
Minor currency pairs, also referred to as cross currency pairs or crosses, are pairings between the rest of the major currencies. They do not include the US dollar. Common crosses include EURGBP and EURJPY.
Compared to the major currency pairs, minor ones are not traded as frequently in the forex market.
Exotic currency pairs are pairings between one major currency and one exotic currency. An example of an exotic pair is the British pound with the South African rand (GBPZAR), and the Japanese yen with the Singapore dollar (JPYSGD).
What is a spread?
In all forex transactions, there are two prices presented for each currency pair: the bid price and the ask price. The bid price is the price of a currency someone offers to buy from you, and the ask price is the price of a currency someone is willing to sell to you for.
The difference between these two prices is called a spread.
Spreads exist in all currency pairs, and their width is influenced by two factors: the volatility of the market price of the currency pair and the liquidity of the specific currency.
A currency’s liquidity is its ability to be bought and sold in the market. When it is being actively traded and can be bought and sold quickly, it has higher liquidity.
In forex, a high spread in a currency pair indicates the pair’s high volatility and low liquidity in the market. Traders who trade with high spreads will have to generate higher profits to offset the higher initial cost.
What is a pip?
Pip, which stands for Point in Percentage, is a unit that measures market price movements. 1 pip refers to the fourth decimal place of a market price. In other words, 1 pip is 0.0001. Pips are small units of measurement, as movements in the market are small.
When GBPUSD moves from 1.4123 to 1.4173, there has been a change of 50 pips. This means that if you bought the pair at 1.4123 and sold it at 1.4173, you would have made a 50-pip profit.
In some currency pairs, such as those involving the Japanese yen (JPY), a pip can also refer to the second decimal place, or 0.01.
This means that when USDJPY moves from 115.30 to 115.31, there will have been a change of 0.10, or 1 pip.
What is a lot?
As movement in the market is small, forex traders generally buy and sell large numbers of units of a currency to make profits. Thus, lots are traded.
A lot contains a specific number of units of a base currency. A standard lot is 100,000 units, a mini-lot is 10,000, and a micro-lot is 1,000. Put in concrete terms, a standard lot of the Singapore dollar is $100,000, a mini-lot $10,000, and a micro-lot $1,000.
To further amplify transaction sizes, forex trading can also be leveraged.
What is leverage?
Leverage is a key feature of forex trading and can be a useful tool for a trader. It allows traders to increase their exposure to an underlying currency beyond their initial investment. Rather than paying the full value of the trade upfront, a trader can put down a deposit, known as margin, and still gain exposure to the total value of the trade.
Margin is the amount of capital required to open a position. Margins vary, depending on the broker, regulations and the currency pair that is being traded.
Leverage is expressed in ratios, which is calculated by dividing the total value of the position by the amount of margin a trader puts up. For example, a leverage of 100:1 means that a full position of a hundred units of a currency has a margin requirement of 1%. In concrete terms, this means that a trader will only have to supply $1,000 to be able to open a position of $100,000 and begin trading.
When a leveraged position is closed, the trader takes on the profits or losses of the full size of the trade. Going back to the previous example, if the trader’s investment value rises to $102,000, they make a profit of $2,000, and they end up with double the amount of money they initially supplied. However, if the investment value falls to $99,000, the trader will lose the entire $1,000 they initially deposited.
Leverage greatly increases exposure, which can be beneficial or detrimental depending on market price movements. Traders should understand the risks involved and always apply leverage with caution.
What influences forex rates?
Forex rates depend on the supply and demand of specific currencies. As the demand for a certain currency increases or decreases, its value relative to other currencies will increase or decrease. This demand of currencies depends upon market sentiment and forex analysis methodologies applied by traders.
Market sentiment is the general attitude of investors towards the currency market, and it is made up of several factors:
- Political news and national events
- Governmental policies
- Economic data such as inflation and interest rates
- Seasonal factors
Ready to trade?
The best way to learn more about the foreign exchange market is to see how prices move in real time and to familiarise yourself with market strategies. Open an FX Trading Account with Saxo today, through which you can access a free demo of our platforms with a simulated USD 100,000 account to practise with.
Saxo Markets also offers a variety of forex options, and clients can expect support throughout the trading day.
Latest Market Insights
Quarterly Outlook Q3 2022: The Runaway Train
- Central banks' attempts to kill inflation is a paradigm shift, which could end in a deep recession.
Tangible assets and profitable growth are the winnersWith US equities officially in a bear market, the big question is where and when is the bottom in the current drawdown?
Understanding the lack of investment appetite among oil majorsThe everything rally seen in recent quarters has become more uneven, as its strength is driven by commodities in short supply.
The pressure is on as the wind leaves the sailsWith cryptocurrencies in sharp decline, are we entering a crypto winter or is the bear market a healthy clean-up of the crypto space?
Why the Fed can never catch up and what turns the US dollar lower?Many other central banks are set to eventually outpace the Fed in hiking rates, taking their real interest rates to levels higher than the Fed will achieve.
Bank of Japan: Swimming against the tideThe Japanese economy has gone from the age of deflation to rapidly rising prices in no time, leaving the Bank of Japan in a pickle.
Green transformation detour and bear market hibernationWith the impending risk of global econonomic derailment, we share the five things investors need to consider in this new half year.
Crisis redux for the eurozone?Whether there's going to be a recession in Europe or not, the path towards a stable economy will be agonizing.
Technical Outlook: Gold, Oil and a remarkable multi-decade perspective on EquitiesThe Nasdaq bubble pattern, USDJPY resistance, crude oil uptrend losing steam and the technical outlook for USD.
China: the train of new development paradigm left the station two years agoChina is transiting to a new development paradigm, as they are hit by deteriorating terms of trade, a slower global economy and an uncertain future while continuing attempts to contain the pandemic.