What is forex?
The foreign exchange market, popularly known as Forex, is the decentralised international market for buying and selling currencies.
Forex is the largest financial market in the world, and is also commonly known as Foreign Exchange, FX or the Currency Market.
The forex market helps companies and individuals convert one currency into another. At the simplest level, we all participate in it when we travel overseas and sell our home currency in exchange for the cash we need to spend abroad.
As well as being traded by individuals and businesses, forex is important for financial institutions, central banks, and governments. It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.
Why trade forex?
Forex trading enables you to speculate on the relative strength of one currency against another.
Forex is the world’s most popular financial market, with an immense volume of trades taking place every day. The majority of these are by speculators buying and selling on intraday price movements.
There is an estimated daily turnover of over $4 trillion in forex trades worldwide. Commercial and financial transactions make up only about 10% of this trading volume.
The large number of traders and immense quantity of currency traded on a daily basis give the forex market exceptionally high liquidity.
This means it’s a very easy market for anyone to access – you can normally buy a currency on demand, because another trader somewhere will be glad to sell it to you, or vice versa.
The forex markets are also free from the commission systems which can complicate some other markets.
Generally you only need a small margin to get started, and there are low transaction costs.
You can trade around the clock and take advantage of high levels of leverage.
How a forex trade works
Forex prices are always quoted in currency pairs. This is because you are effectively buying one currency while selling the other.
Each currency in the pair is known by a three letter currency code, such as GBP/USD (sterling against the US dollar) or USD/JPY (the US dollar against the Japanese yen).
The first currency listed in a pair is known as the base currency. It is also sometimes referred to as the primary currency. The second currency in a forex pair is known as the quote currency, or counter currency.
A forex price indicates how much one unit of the base currency will buy of the counter currency. For example, if you see GBP/USD = 1.63792, this means one pound is worth 1.63792 dollars. To buy one pound, you would have to sell 1.63792 dollars. If you sold one pound you would receive 1.63792 dollars.
Forex trade example
Let’s say a news story has led you to believe that sterling will rise against the Australian dollar. You decide to buy £10,000 of GBP/AUD at 1.41703, which costs you A$14,1703. A few weeks later the price stands at 1.52703, meaning that the £10,000 you hold is now worth more. You decide to take your profit, converting your pounds back into Austrialian dollars for a profit of A$1100 (15,2703 – 14,1703). A breakdown of the transaction can be seen in the table on the right.
Buy 10,000 x 1.41703 10,000 -14,1703
Sell 10,000 x 1.52703 10,000 – 15,2703
Profit from the difference – 1100
Going long and short
Depending on your view, you can either buy (‘go long’) or sell (‘go short’) in the forex markets.
Let’s say you have been keeping an eye on the euro and you think it will increase in value. In this situation, you would go long EUR/USD. In other words, you would buy euros and simultaneously sell dollars.
If you thought the euro was destined to decrease in value, you would go short EUR/USD. That would mean selling euros and buying dollars.
A forex quote will always come with two prices: a selling price (known as the bid price) and a buying price (known as the offer price, or sometimes the ask price). The difference between the two prices is the spread. This is because the broker will incorporate a fee into the price.
The bid price is the price at which you can sell one unit of the base currency.
The offer price is the price you pay in order to buy one unit of the base currency.
Take a look at the quote for EUR/USD on the right.
The bid price is the amount you would receive in dollars (1.43552) in return for selling each euro. This is the maximum that the broker would be willing to pay for euros, in return for selling US dollars.
The offer (or ask) price of 1.43572 dollars is the amount of US dollars you would pay to buy each euro.
Points and pips
The movements of a currency are measured in terms of points or pips. A point, also known as a pip, is generally the fourth digit to the right of the decimal point. So for EUR/USD, a movement from 1.43551 to 1.43561 is one point or pip.