What is Forex Trading?
Forex trading is more popular than ever. On average, the global forex market turns over trillions of dollars a day. That’s trillions, with a “T.” This boom in forex trading has attracted newcomers and beginner forex traders in droves, and the forex market is teeming with investors who are new to the world of currency trading.
In my 20+ years in the forex industry, I’ve learned this about starting out as a forex trader: it’s crucial to develop a solid understanding of the fundamentals before jumping headfirst into the forex market. My “Forex 101” educational series should make it easier to understand the complexities of forex trading and shine a light on the largest, most liquid trading market in the world.
What is forex?
Forex is a common shorthand for foreign exchange; both terms refer to the international exchange of currencies (for example, trading U.S. dollars for Japanese yen). Forex market participants usually either have a need for a particular currency (such as when conducting international business or exchanging currencies at the airport) or want to speculate on the movements in the price directions of currencies to generate a profit (this is commonly known as forex trading).
In this video, I share some quick facts about forex, forex trading, and the forex market:
What is the forex market?
The forex market is where the global exchange of international currencies takes place. The foreign exchange market is the largest financial market in the world, with trillions of dollars traded every single day. According to the latest triennial central bank survey from the Bank for International Settlements (BIS), over-the-counter trading in the forex markets reached $7.5 trillion per day in April 2022.
Did you know?
There is no physical, centralized location or marketplace in which forex trading takes place; the forex market spans the entire globe and is conducted electronically over the counter via a broker-dealer network.
What is forex trading?
Forex trading involves exchanging one currency for another, usually either to hedge the exchange rate to mitigate risk, or to speculate on price movements with the goal of turning a profit.
Hedging: Let’s say there’s an importer in Europe that needs to make a monthly payment in U.S. dollars to its U.S.-based supplier. They’re concerned that the price of the U.S. dollar will go up relative to the euro, which would make it expensive for them to exchange their euros into U.S. dollars for their monthly payment.
The importer could hedge by purchasing a contract that earns money when the euro goes up in value. The hope is that they’ll win in either case; if the euro goes up in value, the importer collects a profit on the contract that offsets any losses incurred when exchanging euros for dollars. If the euro goes down in value, any losses experienced on that contract will be offset by savings made on the exchange rate when it’s time to purchase the U.S. dollars with euros.
Speculation: Forex traders who speculate on the forex market are placing bets on the price direction of a given pair of currencies.
For example, a forex trader might speculate that the price direction of the EUR/USD currency pair will go up. That trader would then purchase the EUR/USD pair (buying euros and paying in U.S. dollars at the prevailing exchange rate) in anticipation that the rate will go up.
When the euro strengthens against the U.S. dollar, it takes more U.S. dollars to purchase the same amount of euros, thus the EUR/USD exchange rate goes up.
If the exchange rate does go up, each euro is worth more dollars than the forex trader paid for them. The forex trader can then close their position by selling the EUR/USD and netting a profit.
Reminder: All currency pairs have two sides: the base currency and the counter-currency. The base currency is on the left side of the currency pair and represents the currency that you are buying or selling. The counter-currency, on the right, reflects the price you are paying for the base currency.
Currency pairs and exchange rates
For the EUR/USD, the euro is the base currency and the U.S. dollar is the counter-currency. When you buy the EUR/USD, you are purchasing euros with U.S. dollars at the prevailing exchange rate.
It’s important for beginner forex traders to learn the universal language of forex trading. Below, we’ll define some of the most common forex terms to help you navigate the forex markets.
A margin-based investment account that permits forex trading, ideally provided by a well-regulated, reliable forex broker (check out my picks for the best forex brokers in the industry). A forex account will provide access to a trading platform that allows you to open and close positions by buying and selling currency pairs.
The “ask” price is the counter-currency price at which you purchase the base currency in a forex currency pair. When you click “buy” you are attempting to buy at the ask price (either to open a new position or close an existing one).
The “bid” price reflects the counter-currency price at which you sell the base currency in a forex pair. When you click “sell” you are attempting to sell at the bid price (either to open a new position or close an existing one).
A pip is a unit of measurement used in the forex market to track changes in the price of a currency (or, changes in the exchange rates of currency pairs).
A pip represents one one-hundredth of a percent. In forex trading, most currency pairs are quoted to the fourth decimal place, so it may be easier to think of a pip as the number in that fourth decimal place.
What is a pip?
Learn more about pips (and try out my handy pip calculator) by visiting my full guide to pips in the forex market.
The spread is the difference in price between the bid and ask prices.
For example, if the GBP/USD exchange rate is 1.4458 for the ask price and 1.4456 for the bid price, that means the spread is two pips.
(1.4458 - 1.4456 = 0.0002, or two pips).
All forex trading is conducted from within margin accounts that allow traders to utilise leverage. In the forex market, leverage refers to the ability to borrow funds from your broker in order to open trade positions. The amount of leverage available varies by broker, account type, platform, and currency pair. Leverage can also be limited and/or restricted by local regulations.
If the margin requirement within a margin account is 10%, that implies a leverage ratio of 10:1. This amount of leverage allows a forex trader to enter the market with a $10,000 position using only $1,000 of margin collateral (or, 10% of the trade value).
More on leverage in the forex market
Leverage has the potential to amplify profits and losses. Learn more by checking out my full guide to how leverage works in the forex market.
When two currencies are quoted against each other, that’s known as a currency pair. Currency pairs allow forex traders to compare the value of two different international currencies.
Each currency in a pair is denoted by its currency code. The first currency code represents the base currency, and the currency after the slash is the quote currency. For the EUR/USD currency pair, for example, “EUR” is the base currency and “USD” is the counter-currency (or, quote currency).
The currency code you see on the left side of a currency pair (EUR/USD) is the base currency (the currency you’ll be buying or selling). The code on the right side of a currency pair (EUR/USD) is the counter currency, which denotes the rate at which the base currency is being bought or sold.
Contract for difference (CFD).
A contract for difference is a type of financial instrument that allows investors to speculate on an asset without taking ownership of the actual underlying asset. CFDs are contracts that represent a specific price for a given asset. By entering into these contracts (CFDs), traders aim to speculate on the price movements of the underlying assets.
More about contracts for difference (CFDs)
Learn more about this popular financial instrument – and find some great CFD brokers – by reading my full guide to CFDs.
Forex Account Types
Micro forex accounts
Micro accounts allow forex traders to trade in increments of 1,000 units, also known as micro contracts or micro lots. Micro accounts don’t limit traders to making trades of 1,000 units, they grant the ability to trade in increments of 1,000. This flexibility can be useful for advanced forex traders who want more precision than may be possible with standard or mini contracts.
Brokers that offer micro contracts may or may not support micro lots, where one lot is equal to 1,000 units. It’s also worth noting that micro contracts are not supported by all brokers (Saxo Bank, for example, is a fantastic forex broker that does not offer micro contracts). On the popular MetaTrader trading platforms, the default lot size is 100,000 (also known as a standard contract).
Mini forex accounts
Mini contracts allow forex traders to trade in increments of 10,000 units of currency, also known as a mini lot. Similar to micro accounts, mini accounts allow you to trade in increments of 10,000.
Standard forex accounts
A standard contract size is for 100,000 units of currency, also known as a standard lot. 10 standard lots is 1,000,000 worth of currency. The most active traders trade hundreds of standard lots per month.
Types of Market Speculation
A futures contract is an agreement to buy or sell an underlying asset at a future date and price.
Did you know?
The futures markets were created to help transfer risk away from those who didn’t want it (hedgers) to those who did (speculators).
A farmer, for example, can use the futures market to hedge against a potential price decline in a commodity they produce. A speculator can take on that risk, hoping for a potential profit.
The farmer’s initial risk (that their produced commodity goes down in price) would be hedged using a futures contract. Any losses incurred on the futures contract could be offset if their initial risk fails to materialize. Likewise, if the price of their produced commodity does fall, the gains made on their futures contract have the potential to offset those losses.
Similar to a futures contract, a forward contract is an agreement to settle a transaction at a future date, at the prevailing price on that date.
The principal difference between a futures contract and a forward contract is that futures are standardized by exchanges and have predefined contract specifications. Forward contracts, on the other hand, are agreements between two parties that can be tailored to the needs of each side and are traded off-exchange (or, over the counter).
Trading any financial asset on the spot implies that there is a prevailing market price that updates throughout the day. A market order, for example, will execute on the spot. If a trader wants to buy the GBP/USD immediately or close an open position they have for the USD/JPY, they are executing a spot trade.
Once a market order is placed to open or close a position, it will be executed on the spot at the next available price (if the present price has changed), provided the market is open and there is sufficient liquidity available.
When you place a limit order, your order will execute when the spot price reaches your limit price. Stop orders (or, stop-loss orders) execute when the current spot market price reaches your order.
While some assets have less frequent price discovery for their spot rate, the forex market is popular for trading on the spot. Prices can update hundreds of times per second across the global network of providers, including banks and brokers.
Continue your forex educational journey
Now that you have a solid understanding of forex, forex trading, and the language of the forex market, check out the rest of my educational series where I dive deep into important concepts like pips in the forex market, leverage, and how to get started as a forex trader.
You can also check out my full educational series on forex scams. The forex market has its fair share of bad actors, scams, and shady brokers. It's crucial that you learn the best practices that can protect yourself from falling victim to forex scams. In this series, I show you how to avoid forex scams and crypto scams, and share advice on what to do if you've been scammed.
What is Currency Trading?