Forex, or foreign exchange, can be explained as a network of buyers and sellers,
who transfer currency between each other at an agreed price. It is the means by which individuals,
companies and central banks convert one currency into another – if you have ever travelled abroad, then it
is likely you have made a forex transaction.
Unlike shares or commodities, forex trading does not
take place on exchanges but directly between two parties, in an over-the-counter (OTC) market. The forex
market is run by a global network of banks, spread across four major forex trading centres in different
time zones: London, New York, Sydney and Tokyo. Because there is no central location, you can trade forex
24 hours a day.
A base currency is the first currency listed in a forex pair, while the second
currency is called the quote currency. Forex trading always involves selling one currency in order to buy
another, which is why it is quoted in pairs – the price of a forex pair is how much one unit of the base
currency is worth in the quote currency.
Each currency in the pair is listed as a three-letter
code, which tends to be formed of two letters that stand for the region, and one standing for the currency
itself. For example, GBP/USD is a currency pair that involves buying the Great British pound and selling
the US dollar.
So in the example below, GBP is the base currency and USD is the quote currency. If
GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.
If the pound rises against
the dollar, then a single pound will be worth more dollars and the pair’s price will increase. If it
drops, the pair’s price will decrease. So if you think that the base currency in a pair is likely to
strengthen against the quote currency, you can buy the pair (going long). If you think it will weaken, you
can sell the pair (going short).
There are a variety of different ways that you can trade forex,
but they all work the same way: by simultaneously buying one currency while selling another.
Traditionally, a lot of forex transactions have been made via a forex broker, but with the rise of online
trading you can take advantage of forex price movements using derivatives like CFD trading.
CFDs
are leveraged products, which enable you to open a position for a just a fraction of the full value of the
trade. Unlike non-leveraged products, you don’t take ownership of the asset, but take a position on
whether you think the market will rise or fall in value.
Although leveraged products can magnify
your profits, they can also magnify losses if the market moves against you.
The spread is the
difference between the buy and sell prices quoted for a forex pair. Like many financial markets, when you
open a forex position you’ll be presented with two prices. If you want to open a long position, you trade
at the buy price, which is slightly above the market price. If you want to open a short position, you
trade at the sell price – slightly below the market price.
Currencies are traded in lots – batches
of currency used to standardise forex trades. As forex tends to move in small amounts, lots tend to be
very large: a standard lot is 100,000 units of the base currency. So, because individual traders won’t
necessarily have 100,000 pounds (or whichever currency they’re trading) to place on every trade, almost
all forex trading is leveraged.
