TL;DR - SUMMARY
Forex is the largest market in the world by trading volume and liquidity. Brokers, companies, governments and other economic agents trade currencies and currency derivatives to enable international trade.
Traders also use the market for speculative reasons. Various arbitrage opportunities can be found with exchange rates and interest rates, making the market popular for trading in large volumes or with leverage.
The forex market is made up of fiat currency pairs and their relative market prices. These pairs are typically bought and sold in lots. A standard lot contains 100,000 units of the pair's base currency, but there are other smaller sizes available, ranging up to 100 units.
Traders often use leverage to increase the amounts they can invest with their capital. You can also offset risk by using forwards and swaps to trade a currency pair for a specific price in the future. Combining these two instruments with other trading products and strategies creates a variety of investment opportunities for forex traders.
Introduction
Even if you don't trade forex, the international currency market often plays an important role in your daily life. While the effects of a stock market crash are not always so obvious, a change in the value of your currency can affect the price of goods and services. If you've been abroad, you've probably also had to change your currency and pay a fee that depends on current quotes and exchange rates.
Forex is a unique asset class that differs from stocks, commodities and bonds. When we dive into what makes it different, it is clear why such a large market exists and the need for a truly global forex market.
What is forex?
Forex or FX trading (from Foreign exchange) is the buying and selling of sovereign currencies and other forex products. When exchanging currencies at a bank or exchange office, the rates we encounter are directly determined by what happens in the forex market.
Exchange rate movements are based on a combination of economic conditions, world events, interest rates, politics and other factors. As a result, forex is highly liquid and has the highest trading volume compared to other financial markets.
The forex market comprises two main activities: trading that facilitates economic transactions and speculative trading. For companies and other entities that operate in international markets, the purchase and sale of currencies is an obligation. Getting your funds back home or purchasing goods abroad is a key use case of the foreign exchange market.
Speculators are the other side of forex trading. Short-term, high-volume trading that takes advantage of very small fluctuations in currency prices is common. Forex is a market full of arbitrage opportunities for speculators, which partly explains the large amount of trading volume in the market.
Traders also look to make money from long-term opportunities, such as fluctuating interest rates. Economic events and geopolitics also cause serious fluctuations over time in currency markets. By buying a coin now and holding it, long-term profits can be made. You can also agree forward-looking exchange rates with futures contracts in a bet with or against the market.
Forex can be challenging for younger users. Without borrowing or having a large amount of initial capital, arbitrage and short-term trading become much more difficult. This aspect has led to international banks and financial institutions providing most of the volume we see in the foreign exchange market.
What is a forex pair?
At the most basic level, the forex market contains currency pairs that describe the relative price between the two. If you have already traded cryptocurrencies, you will be somewhat familiar with how the forex market works. The first currency displayed in a pair is the base currency. The second is the quote currency, sometimes known as the counterpart currency. We express the quote currency as a value related to a single unit of the base currency.
GBP/USD shows the price of 1 GBP quoted in USD. This ratio is displayed as a number, such as 1.3809, showing that 1 GBP is worth 1.3809 dollars. GBP/USD is one of the most frequently traded pairs and is known as cable. This nickname comes from a 19th century transatlantic cable that relayed this rate between exchanges in London and New York.
When it comes to forex trading, you can find many liquid markets. Some of the pairs with the highest trading volume are USD/JPY, GBP/USD, USD/CHF and EUR/USD. These pairs are known as the major pairs and consist of the US dollar, Japanese yen, British pound sterling, Swiss franc, and euro.
Why do people trade forex?
The forex market is not just about speculation. Banks, companies and other parties that need access to foreign cash engage in forex trading to facilitate international transactions. Companies also agree exchange rates in advance to lock in the costs of future currency exchanges, known as hedging. Another use case is for governments to build up reserves and meet economic goals, including pegging currencies or boosting imports/exports.
For individual traders, the forex market also has attractive features:
Leverage allows even small traders to invest with larger sums of capital than they have direct access to.
Entry costs are low, as it is possible to purchase small amounts of currency. Buying a stock in the stock market can cost you thousands of dollars, compared to entering the foreign exchange market for $100.
You can trade at almost any time, making the forex market suitable for all times.
There is high liquidity in the market, as well as a low bid/ask spread.
Options and futures are standard products. Shorting the market is possible for traders who not only want to buy and sell spot at the current market price.
Where do people trade forex?
Unlike stocks that are primarily traded on centralized exchanges like the NYSE or NASDAQ, forex trading takes place in centers around the world. Participants can trade directly with each other via over-the-counter (OTC) or tap into a huge network of banks and brokers in the interbank market.
Supervising this international currency trade can be complicated due to the different regulations of each currency. While many jurisdictions have agencies that oversee trading within the domestic market, their international reach is limited. While you may need to acquire a license or go through a reputable broker for your forex trading, this does not stop traders from simply using other, less regulated markets for their activities.
Four main areas make up the majority of forex trading volume: New York, London, Tokyo and Sydney. Since the forex market has no central point, you should be able to find a brokerage that can help you trade currencies around the world.
There are a wide variety of options available for online brokerage services that are generally free. You will not pay a direct commission, but forex brokers will maintain a spread between the price they offer and the actual market price. If you are just starting out, choose a broker that allows you to trade micro lots. We will cover this point later, but it is by far the most accessible way to start trading forex.
What makes forex trading unique?
Forex has many aspects that differentiate it from other financial markets:
It has a large geographical coverage. There are 180 foreign currencies recognized around the world, creating markets for them in almost every country.
It is extremely liquid and has a huge trading volume.
Their market prices are affected by numerous global factors. These include politics, economic conditions, speculation, remittances and more.
It is open to the market approximately 24 hours a day, five days a week. Because the market is not completely centralized, there is almost always an exchange or brokerage available for your use. Markets are closed on weekends, but after-hours trading is still available on some platforms.
Their profit margins can be low unless you operate in high volumes. Slight differences in the exchange rate can be made profitable through large transactions.
How do people trade forex?
There are a few choices when it comes to forex that individual traders can make. The easiest way is to buy a currency pair on the spot market and hold it. For example, buy EUR in the USD/EUR pair. If the counter currency appreciates, you can sell it for your base currency and make a profit.
You can also leverage your funds to increase the amount of capital available to you. In this case, you can trade with borrowed funds as long as you cover your losses. Another possibility to consider is forex options that allow you to buy or sell a pair for a fixed price on a specific date. Futures contracts are also popular, which obligate you to place a trade at an agreed price in the future.
An interesting aspect of forex trading is the possibility of making profits through interest rate differentials. Central banks around the world set different interest rates that provide investment opportunities for forex traders. By exchanging your cash and depositing it in a foreign bank, it is possible to earn more money than if you leave your funds at home.
However, there are additional costs, including remittance fees, bank charges, and different tax regimes. You must consider all possible additional costs to make your strategies work. Arbitrage opportunities and profits are usually minimal, so your margins will be small. An unexpected commission can wipe out all the expected profits.
What is a pip?
A pip (percentage in points) is the smallest possible price increase a forex pair can make. Looking at GBP/USD again:
A move up or down of 0.0001 would be the minimum amount the pair can move (1 pip). However, not all currencies operate to four decimal places. Any pair with the Japanese yen as the standard quote has a pip of 0.01 because there is no decimalization of the currency.
Pipettes
Some brokers and exchanges break the standard and offer pairs that extend the number of decimal places. GBP/USD, for example, will go to five decimal places instead of the usual four. USD/JPY usually has two decimal places, but can go up to three. This extra decimal is known as a pipette.
What is a lot in forex trading?
In forex trading, currencies are bought and sold in specific quantities known as lots. Unlike stock markets, these lots of foreign currencies are traded at set values. A lot is usually 100,000 units of the base currency in a pair, but you can also purchase smaller quantities, including mini, micro and nano lots.
When working with lots, it is easy to calculate your profits and losses with pip changes. Let's look at EUR/USD as an example:
If you buy a standard lot of EUR/USD, you have bought 100,000 EUR for 119,380 USD. If the pair increases its price by one pip and you sell your lot, this is equivalent to a change of 10 units of the quoted currency. This appreciation means that you will sell your 100,000 EUR for 119,390 USD and make a profit of 10 USD. If the price increases by ten pips, then it will be a profit of 100 USD.
As trading has become increasingly digitalized, standard lot sizes have declined in popularity in favor of more flexible options. On the other hand, large banks have even increased their standard lot sizes up to 1 million to accommodate the large volume they operate.
How does leverage work in forex trading?
One of the unique features of the forex market is its relatively small profit margins. To improve your profits, you will need to increase the volume you are trading. Banks can do this quite easily, but people may not have access to enough capital and can use leverage instead.
Leverage allows you to borrow money from a broker with relatively little collateral. Brokers display leverage amounts as a multiplication of the capital provided, for example, 10x or 20x equals 10 or 20 times your money. 10,000 USD leveraged 10x would give you 100,000 USD to trade.
To borrow this money, traders maintain a margin amount that a broker uses to cover potential losses. A 10% margin is 10x, a 5% margin is 20x, and 1% is 100x. Through leverage, you experience the total gains or losses of an investment based on the total amount leveraged. In other words, leverage amplifies your profits and losses.
Let's look at an example. If you wanted to buy one lot of this pair (100,000 EUR), you would need approximately 120,000 USD at the current price. If you are a small trader without access to these funds, you could consider getting 50x leverage (2% margin). In this case, you only need to provide 2,400 USD to access 120,000 USD in the forex market.
If the pair goes down 240 pips ($2,400), your position will be closed and your account will be liquidated (you will lose all your funds). When you leverage, small movements in price can cause sudden, large swings in your profits or losses. Most brokers will allow you to increase your account margin and top it up as needed.
How does hedging work in forex?
With any floating currency, there is always a chance that the exchange rate will move. While speculators try to profit from volatility, others value stability. For example, a company that plans to expand internationally may want to lock in an exchange rate to better plan its expenses. They can do this quite easily with a process called hedging.
Even speculators may want to lock in a specific exchange rate to protect themselves against an economic shock or financial crisis. You can start hedging your exchange rates with various financial instruments. The most common methods are the use of futures or options contracts. With a futures contract, an investor or trader is obligated to trade at a specific rate and amount at a future date.
Futures contracts
Suppose you enter a futures contract to buy one lot of USD/EUR at 0.8400 (you buy 100,000 USD for 84,000 EUR) in one year. Maybe you are selling in the Eurozone and want to repatriate your profits in a year. A futures contract eliminates the risk of a possible appreciation of the US dollar against the euro and helps you better plan your finances. In this case, if the US dollar appreciates, each euro will buy fewer dollars as the funds are repatriated.
If the US dollar appreciates and the USD/EUR is at 1.000 However, instead of this commission, you would enter the previously agreed contract of one lot of USD/EUR at 0.8400 (100,000 USD for 84,000 EUR). In this simple example, you will have saved a cost of 16,000 EUR per lot, without taking into account any commission.
Options
Options offer a similar way to reduce risk through hedging. But unlike futures, options give you the option to buy or sell an asset at a predetermined price on or before a specific date. After paying a purchase price (the premium), an option contract can protect you from unwanted appreciation or depreciation in a currency pair.
For example, if a British company sells goods and services in the US, they could buy a GBP/USD call option. This instrument allows them to buy GBP/USD in the future at a predetermined price. If the pound has appreciated or maintained its rate when payment is made in US dollars, the company has only lost the price paid for the options contract. If the pound depreciates against the dollar, they will have already covered their rate and will be able to obtain a better price than what is offered in the market.
For more information about futures and options contracts, see What are forwards and futures contracts? and What are options contracts?
Covered interest rate arbitrage
With interest rates varying around the world, forex traders can arbitrage these differences while compensating for the risk of the exchange rate moving. One of the most common ways to do this is with covered interest rate arbitrage. This trading strategy hedges the future price movements of the currency pair to reduce risk.
Step 1: Find an arbitrage opportunity
Take, for example, the EUR/USD pair with a rate of 1,400. The interest rate for deposits in the Eurozone is 1%, while in the US it is 2%. So, 100,000 EUR invested in the Eurozone will return you 1,000 EUR profit after one year. However, if you could invest the money in the US, it would provide you with 2,000 EUR profit if the exchange rate holds. However, this simplified example does not take into account fees, banking costs, and other expenses that you should also take into account.
Step 2: Hedging your exchange rate
With a one-year EUR/USD futures contract with a forward rate of 1.4100, you can take advantage of the improved interest rate in the US and guarantee a fixed return. The forward rate is the agreed exchange rate used in the contract.
A bank or broker calculates this rate with a mathematical formula that considers different interest rates and the current spot price. The forward rate adds a premium or discount compared to the spot rate depending on market conditions. In preparation for the arbitrage, we enter into a futures contract to sell one lot of EUR/USD at a rate of 1.41 in one year.
Step 3: Complete the arbitration
In this strategy, you buy a lot of EUR/USD at 1,400 in the spot market to give you 100,000 EUR for 140,000 USD. Once you have the funds from your spot trade, deposit them in the US for one year with 2% interest. When the year ends, you will have 142,800 USD in total.
The next step is to convert the 142,800 USD to Euros. With the futures contract, you short the 142,800 USD at the agreed rate of 1.4100, which gives you approximately 101,276.60 EUR.
Step 4: Compare Earnings
Let's compare the profit you make here with and without rate hedging, assuming everything else holds. After going through the US covered interest arbitrage strategy, you will have 101,276.60 EUR. If it were not covered, you would have 102,000 EUR, as mentioned above. So why do people protect themselves if this results in less profits?
Mainly, traders hedge to avoid the risk of exchange rate fluctuations. A currency pair will rarely remain stable for a year. So, while the profit is 723.40 EUR less, we have managed to at least guarantee 1,276.60 EUR. Another factor is that we assume that the central bank will not change the interest rate during the year, which is not always the case.
In conclusion
For anyone interested in international economics, trade and global affairs, the forex market offers a unique alternative to stocks and securities. Forex trading may seem less accessible than cryptocurrencies or stocks for small investors. But with the rise of online brokers and increasing competition to bring financial services to the public, forex is not so out of reach. Many forex traders rely on leverage to make decent profits. These strategies carry a high liquidation risk, so make sure you understand the mechanisms very well before taking risks.