How Foreign Exchange Markets Work – iExpats.com

Foreign exchange, forex or FX mean the same thing – the global currency marketplace where traders, banks, and institutions swap one currency for another and buy or sell in currency pairs.

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Forex is a unique beast and a market that moves very quickly, handles trillions of pounds worth of daily transactions and is the most liquid on the planet.

There is no governing body or centralised location, but you need a forex broker to take a position or make a trade.

The biggest securities market worldwide uses currency pairs, where one denomination is quoted a price relative to the other, and traders use a variety of approaches, such as futures and forwards, to try and outplay the market.

The Basics Of Forex Markets

Market values dictate how much any currency is worth daily, known as the exchange rate.

Travel money dispensers and banks use those exchange rates to determine how much you get when you spend your cash for another currency at any particular time or when you pay for something overseas or from a foreign supplier.

If you find that your holiday budget doesn’t stretch as far, it’s very likely because GBP has weakened or the other currency has strengthened.

Traders use changing exchange rates to make a return and guess which way a currency might move to try and profit. For example, if you think EUR is about to soar, you could buy that currency now and resell once the price has risen; if, of course, you end up being right.

The US dollar is the most influential currency in the forex market because it is the most actively traded. Common pairs include the USD against GBP, AUD, JPY or EUR. Any currency pair that excludes USD is called a cross, typically EUR/GBP or EUR/JPY.

Forex spot markets can move quickly and dramatically, and short-term traders use technical analysis to make decisions based on how the currency is trending and how fast.

Longer-term forex trades are based on fundamental analysis such as GDP, economic circumstances and interest rates in each respective country.

Forex Trade Example

As an illustration, a forex trader might anticipate that the European Central Bank is about to announce monetary policy easing to try and support an ailing economy, resulting in the euro dropping against the USD.

If their expectations are correct, they sell €100,000 short at 1.15. The exchange rate falls to 1.10, which means the trader makes a profit of $5,000.

Because the trader shorted €100,000 at 1.15, they covered a trade worth $115,000. The euro fell in value, and buying back the same currency cost $110,000 hence a differential, and a gain, of $5,000.

If the trade was incorrect and EUR had strengthened, they would have made a loss using the same calculation.

Currency Pairs In Forex

Currencies are always listed in pairs, such as:

  • USD/CAD: US dollars vs Canadian dollars
  • EUR/USD: euros vs US dollars
  • USD/JPY: US dollars vs Japanese yen

Each pair has an associated price, so if the price for USD/CAD were 1.2569, it would cost $1.2659 in Canadian dollars for each USD.

Forex traders use lots, which are standardised blocks of currency trade volumes. One standard lot is 100,000 units, a mini lot 10,000, a micro lot 1,000 and a nano lot 100 units.

For example, seven micro lots would mean a trade of 7,000 units, and seven standard lots would mean 700,000 currency units.

Currency markets use these transaction blocks because the trading volume is vast and averages around £5.91 trillion every 24 hours.

Brokers often won’t deal with trades any smaller than a micro lot because the margins and transaction costs aren’t worth it for such a small transaction.

Although forex is decentralised and isn’t controlled by any organisation, the biggest trading centres are Hong Kong, Tokyo, Singapore, New York and London.

How To Trade Forex

Forex markets do not close overnight and are open 24 hours a day, Monday to Friday, everywhere in the world.

Trades are entirely digital and placed through online brokers, and no actual currencies change hands. Instead, you take a position against your selected currency based on whether you think it will move up or down.

The market differs considerably from other investment markets.

Forex has few rules, although regulators in specific countries might limit things like the maximum leverage ratio a regulated forex broker can offer. The market doesn’t have any oversight body or a clearinghouse.

Brokers tend to make their profits through spreads – the difference between quoted and actual currency prices – and low commissions and transaction fees.

Investors can buy as much of any currency as they like since there are no upward limitations on transaction sizes and the market is highly liquid.

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Forex Transaction Types

The primary three trades within forex are spot, forward and futures.

Spot market

The spot market is the simplest option, with spot rates referring to the exchange rate at any given point in time. When you make a spot forex trade, you buy one currency with another at that rate.

Most spot transactions settle within two business days, except USD/CAD, which settles the following business day.

The trade is settled at the quoted spot rate when the transaction is initiated, regardless of how long it takes for the trade to be finalised and the money exchanged.

Forwards

Forward trades mean that you create a transaction that will settle at a later date. The quoted forward price combines the spot rate and any forward points, plus or minus, representing the differential between the current interest rates.

In forex, forward trades tend to mature in less than 12 months, but longer terms are available. Prices are set on the transaction date, but no cash changes hands until the term ends.

Brokers customise forward trades to the parties involved, which can be for any value, and settle on any date, provided it isn’t a holiday or weekend in either country.

Futures

Futures might sound like forwards, but they are the only type of forex trade that is made through an exchange – the Chicago Mercantile Exchange.

A forex future is a derivative contract where the buyer and seller agree to the transaction on a fixed date and for a fixed price.

International companies often use futures to hedge against heavy currency fluctuations, where they use foreign currency for their overseas business affairs, and speculators also use futures to try and return a profit.

The Risks And Rewards Of Trading Forex

Forex was traditionally a market only available to financial institutions, and the advent of online brokerages, trading apps and digital accounts has transformed the way it works.

Investors like the low entry costs and that forex markets do not close like a conventional stock market with limited trading hours.

There are thousands of forex brokerages, including those with demo accounts and educational resources for novice traders.

The downsides are that forex is volatile and uncertain and can easily lose a lot of money, particularly with highly leveraged trades. Professional and institutional traders use technology to predict price movements and analyse economic metrics that influence exchange rates.

It is a high-risk market with significant competition. Traders need to move quickly when conditions change because a profitable position may soon become much less so.

How Foreign Exchange Markets Work FAQ

What are forex pairs?

Currency pairs are two currencies that are traded against each other – and you can choose from hundreds of pairs, although most traders use the majors, including EUR/USD, GBP/USD or USD/JPY.

What are base and quote currencies in FX?

Each forex transaction has two prices depending on which currency you buy and which you sell.

The base currency is always on the left, which is taken as one unit.

The quoted currency on the right is valued at the current market rate, so you must pay that price multiplied by however many units of the base currency you wish to trade.

What are forex pips?

A pip is the fourth digit after the decimal in a forex price. For example, if you have a quote of 1.3536, the pip is the six. Pips indicate the smallest margin a currency price can change by.

Why do forex markets use lots?

Lots are standardised transaction volumes measured in units. A standard lot is 100,000 units of whatever base currency you use. You can also trade mini, micro and nano lots with smaller currency unit volumes.

What is a forex margin?

Your margin is the deposit you make with a forex broker to open and maintain a position, and it also indicates the maximum leverage you can borrow.

For example, you might want to open a EUR/GBP trade with a 3.33 per cent margin, so you need to deposit £3,300 to open a position on one lot worth £100,000.

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