Introduction to financial markets
What is forex?
The foreign exchange market – also known as forex or FX – is the world’s most traded market.
According to the Bank for International Settlements, global forex trading in 2019 averaged over $6 trillion each day. To put that into context, trading on the stock market averages around $230 billion each day.
Which might seem like a lot, but it is just 4% of the total volume seen in FX.
What is forex trading?
Forex trading is the buying and selling of global currencies. It’s how individuals, businesses, central banks and governments pay for goods and services in other economies. Whenever you buy a product in another currency, or exchange cash to go on holiday, you’re trading forex.
However, the vast majority of forex trades aren’t for practical purposes. Speculative FX traders seek to profit from fluctuations in the exchange rates between currencies, speculating on whether one will go up or down in value compared to another.
How FX trading works
Forex is traded in pairs, meaning that when you trade forex, you’ll always exchange one currency for another. When buying EUR/USD, for example, you’re buying euros while selling the US dollar.
- If the euro strengthens against the dollar, your position will increase in value
- If the euro weakens against the dollar, it will decrease in value
Currency markets never decline in absolute terms – for one currency to go up, there will be others weakening against it. All currencies cannot go up at the same time. There is always going to be a winner and a loser.
So FX traders weigh up whether a currency looks likely to strengthen or weaken against another, then trade that pair accordingly.
Who trades currencies?
Currency markets are crucial to a broad range of participants. Any company that buys or sells overseas, for example, will need to exchange one currency for another as part of their daily operation. Central banks can also be active FX traders, as they seek to keep the currencies they are responsible for under control.
However, global FX trading is dominated by just ten banks, who are responsible for around two-thirds of the world’s volume.
The size of the forex market makes it both highly liquid and dynamic. This high market liquidity means prices can change rapidly in response to news and short-term events, creating multiple trading opportunities each day. Banks trade forex with each other 24 hours a day, attempting to take advantage of these opportunities to earn a profit and hedge against risk.
The rise of leveraged trading in recent decades has also enabled more and more individual retail traders to enter the world of FX. While retail FX traders might not be responsible for as much of the world’s volume, they act in a similar way to the ten big banks – identifying when a currency might be in for a significant price move and trading accordingly.
How FX is traded
One key difference between forex and other markets (such as shares and commodities) is how currencies are bought and sold. Instead of trading via a central exchange such as the New York Stock Exchange or London Stock Exchange, forex prices are determined by interbank trading – the buying and selling of currencies between banks constantly, all over the world.
When banks in one time zone close, those in another one open. This means that thecurrency market is open 24 hours a day.
Each currency quoted in a pair is written as a three-letter code. Here’s a list of some popular currencies, and their corresponding codes:
Why trade forex?
But being open 24 hours isn’t the only benefit to trading forex. There are two other key reasons why it’s the world’s most popular market:
Going long or short
When investing in stocks, bonds or funds, you can traditionally only speculate on one price direction: up.
Forex trading is a little different. Because you are buying one currency while selling another at the same time, you can speculate on both upward and downward market moves.
Volatility and liquidity
With so many trades happening each second, currency prices are always on the move – which brings lots of opportunity for traders.
It also means that there lots of available buyers and sellers, which keeps supply high and tends to keep trading costs competitive.
We’ll go into short selling, volatility and liquidity in more detail in the Trading basics course.
Is forex trading right for me?
Forex trading is ideal for investors who want the opportunity to trade a market that is open 24 hours a day, while minimising trading costs and potentially profiting from markets that are rising or falling. However, it contains significant risks to your money and is not suitable for everyone.
Forex trading is ideal for people who:
- Are looking for short-term opportunities. FX traders typically hold positions for a few days or weeks, rather than over the long term
- Want to make their own decisions. Most FX brokers provide an execution-only service. That means they do not advise you on what to trade on and do not trade on your behalf
- Are looking to diversify their portfolio. Trading currencies can be a great way of getting global exposure
Test your knowledge
- A NZD
- B KWI
- C NZP
- A Buying GBP while selling USD
- B Buying USD while selling GBP
- C Buying coconuts while selling USD
- A Hungarian Forint
- B Honduran Franc
- C None of them
- A Zimbabwe
- B South Africa
- C Zaire