What is Forex?
Forex is the largest financial market in the world, with an estimated daily turnover of around $5 trillion according to the BIS Triennial Survey. This is $5,000 billion in a single day! By size, the Forex market dwarfs all other financial markets – even the stock and bond market combined don’t come close to the trading volume of the FX market.
So, what is Forex exactly? As you already assume, the Forex market is the trading place of the world’s currencies. Currencies are traded in major financial centers around the world, which means that Forex is open 24 hours a day, 6 days a week (except Sundays, when all trading centers are closed). Compared to the stock market which can be traded only when the stock exchange is open, the ability to trade and manage your positions around the clock is one of the major advantages of Forex.
Retail Forex – which is the place where you and I can trade – emerged with the advance in technology and the evolution of internet and trading platforms. Now, all you need to start trading on the largest financial market in the world is an active internet connection, a brokerage account and a trading software.
What is Forex Trading?
The answer the question “what is Forex trading?”, let’s give a brief overview of how it all started. A few decades ago, small investors were not able to participate in the Forex market. Due to the large capital required to trade on currencies and other trading barriers, the only market participants were large banks, hedge funds, multinational companies and governments through their central banks. Today, these mentioned players still dominate in the overall trading volume, but retail Forex experienced a whopping increase in trading volume and now accounts for around 5% of the total daily trading volume, which still equals to $250 billion.
Retail Forex traders try to buy a currency cheap and sell it later at a higher price. However, Forex traders can also profit from a fall in the price by short-selling a currency pair. Similar to stock traders, Forex traders try to predict where an exchange rate is heading and make their trading decisions based on that assumption.
However, if you’re new to the markets and don’t have any trading experience, it’s strongly recommended to open a demo account first. A demo account offers a risk-free way to get familiar with the broker’s trading platform and with trading itself without risking real money.
Top 3 Forex Broker Comparison
Forex vs Other Markets
Before we give a more detailed answer on what is Forex trading and how does it work, let’s compare Forex to other financial markets. We’ve already mentioned one of the major advantages of Forex compared to the stock market, which are the open market hours. However, there are a few more important advantages which are listed below:
- Forex is open around the clock – You can place trades and manage them around the clock, as long as a trading session is open somewhere in the world. With major centers spanning from New York, over London to Sydney and Tokyo – there is always an open trading session around the clock.
- Forex trading features a high degree of leverage – While stocks are usually traded with a leverage up to 20:1, currencies feature a significantly higher leverage that with some brokers can be as high as 400:1. This means that with every dollar deposited with the broker, you’re able to control a trade as large as $400.
- Eight major currencies vs. thousands of stocks – There are only eight major currencies (and a dozen of minor currencies) in the Forex market. This is still a lot less than thousands of stocks on the NYSE – and easier to follow.
- Lower insider trading – the large daily volume makes it almost impossible to manipulate the Forex market. Stocks, on the other hand, can easily be influenced by rumors, CEO resignations or information that only a handful of investors know in advance.
What are the Major Currencies in Forex?
By now, you know that there are eight major currencies in Forex. Let’s cover them now in more detail.
The major currencies are the US dollar (USD), euro (EUR), British pound (GBP), Swiss franc (CHF), Japanese yen (JPY), Australian dollar (AUD), New Zealand dollar (NZD) and Canadian dollar (CAD). If we expand this list to include all G10 currencies, than the Norwegian krona (NOK) and Swedish krona (SEK) make it also to the list.
As you can see, the currencies of the major world economies are listed above, which is no surprise considering that those countries have the largest GDP and trade volume in the world. Multinational companies based in those countries are one of the major players on the FX market, as they sell their products overseas in foreign currencies, and have repatriate their earnings in their domestic currency.
The major currencies can be further grouped by their characteristics. In this regard, the euro and US dollar are important reserve currencies held by central banks around the world, the Japanese yen and Swiss franc are considered safe havens (partly because of their large trade surpluses) and rise in times of economic and political turmoil, and the Australian and Canadian dollar are also called commodity currencies because of their high correlation to the price of gold, iron ore and oil.
Why You Need to Follow Minor and Exotic Currencies
The US dollar is involved in around 80% of all Forex transactions, which makes it the single most traded currency in the foreign exchange market. In terms of currency pairs, EUR/USD is the most traded and most liquid currency pair in the world.
Now, this leads us to an important issue that many Forex traders overlook. Liquidity is inversely correlated with volatility, i.e. the more buyers and sellers exist at any given price level, the lower is the volatility (price-change relative to time) of that financial instrument. Major pairs – which are pairs that consist of the US dollar and one of the other major currencies – usually have the lowest average volatility. Cross-pairs – which consist of two major currencies except the US dollar (e.g. EUR/CHF, GBP/JPY…) – have a relatively higher volatility than major pairs. And finally, exotic pairs have the highest volatility as they have the smallest number of buyers and sellers.
Volatility is what creates trading opportunities, and minor and exotic currencies are far more volatile than their major peers. Currencies such as the Turkish lira or Mexican peso can move thousands of pips in a single day, so make sure to take this into account on your trading journey from a beginner to a professional trader.
How Currencies are Quoted
All currencies are quoted in pairs. A currency pair consists of two currencies – the first one called the base currency, and the second one called the counter currency. The resulting exchange rate of a currency pair reflects the price of the base currency expressed in terms of the counter currency. Let’s explain this with an example.
If the current market rate of EUR/USD is 1.20, this means that “one euro buys 1.20 US dollar”, or “it takes 1.20 US dollar to buy one euro.”
Similarly, if GBP/JPY (British pound vs. Japanese yen) trades at 150.00, this means that “one pound buys 150 yen”, or “it takes 150 yen to buy one pound.”
The smallest amount the price of a currency pair can change is called a pip – this is the fourth decimal of an exchange rate. For example, if EUR/USD rises from 1.2050 to 1.2054, this equals to a rise of 4 pips.
One more concept you need to be aware about is the spread. The spread is simply the difference between the bid and ask prices of a currency pair. The bid price is the price at which the market buys a currency from you, and the ask price is the price at which the market sells a currency to you. The spread is usually the main source of profit of a Forex broker.
How do Forex Traders Analyze the Market?
Now that you know what is Forex and what is Forex trading, it’s time to see how Forex traders analyze the market.
A Forex trader, similar to a stock trader, buys a currency cheap and sells it later at a higher price. As Forex traders don’t know for sure what the future exchange rate of a currency pair will be, they need to analyze the market, identify potential trading opportunities and anticipate whether a currency will fall or rise in the coming period.
Evidence shows that this is not an easy endeavor, as there are dozens of factors that influence an exchange rate over time. Current economic, social and political conditions in a country, major technical price levels which hide a significant number of buy or sell orders, or the general sentiment of market participants can all have an impact on the value of a currency pair over the short, medium or long-term. Most retail Forex traders focus on short-term trading, which makes it important to learn the various forces that drive exchange rates up and down. It’s often said that trading is as much art as science, because we cannot find two identical traders who see the same trade setups or take the same technical levels into account in their trading.
Major Analytical Disciplines of Forex Traders
While giving a detailed explanation of how traders analyze the Forex market and make their trading decisions would be out of the scope of this article, let’s give a brief overview of the major analytical disciplines used in the Forex market.
- Technical analysis – This is by far the most popular way of analyzing the market among retail Forex traders. The reason? It works. Technical analysis can be successfully utilized both on short-term and long-term timeframes, and if you’re serious about becoming a trader, technical analysis is on the top places of your learning list. Technical analysis is based on analyzing past price-action to predict future price movements.
- Fundamental analysis – Another major type of market analysis is fundamental analysis. In the Forex market, fundamental analysis tries to measure the equilibrium exchange rate between two currencies, i.e. the exchange rate that is fundamentally justified. To do so, fundamental analysts need to track the economic growth of a country, the inflation and interest rates, trends in productivity and balance of payments, the situation in the labour market and so on. Fundamental analysis returns the best results when applied over a medium to long-term trading horizon.
- Sentiment analysis – The third major analytical discipline is sentiment analysis. Market sentiment measures the optimism and pessimism among market participants, i.e. does the majority of traders think that a currency will fall or rise in value.
What is Forex trading and how does it work?
In this article, you’ve learned what is Forex trading and how does it work. Let’s conclude it with a few more tips that may help you to master the art of online forex trading.
Forex is the largest financial market in the world and the marketplace of the world’s currencies. In order to start trading on Forex, all you need is an internet connection, a brokerage account and a trading platform provided by your broker. While most Forex brokers don’t require large initial deposits, you should still start with a demo account first and trade with virtual money until you’re completely ready for a real account.
All currencies are different and have their own personalities, so make sure to dedicate enough time to learn their major characteristics and the basics of analyzing the market, and – combined with a solid risk management – you’re on a good way to become a successful Forex trader.