What is forex trading – and how does it work?

Get to grips with the fundamentals of forex trading here. Including why foreign exchange is such a popular market, how to buy and sell currencies, the types of forex pair and more.

Or, try it for yourself first hand:

What is forex?

Forex is a financial market, short for foreign exchange. Forex simply means buying one currency while selling another. It's how you change money to go abroad, or import something from a different country.

Individuals, businesses and governments around the world all buy and sell billions of dollars of forex each and every day.

But this activity makes up a tiny fraction of the market. It's dwarfed by forex trading.

What is forex trading?

Forex trading is the buying and selling of currencies to make a profit. Forex traders try to take advantage of fluctuations in exchange rates, speculating on where a currency might be headed next.

The forex market is the biggest financial market in the world. According to the Bank for International Settlements, it has a turnover of more than $7.5 trillion each day.

The huge volume of forex traded each day means that currency prices are constantly moving against one another. The US dollar, for example, is always going up or down in value. In forex trading, you aim to use this to make money.

How does forex trading work?

Forex trading works using pairs. When you trade forex, you're buying one currency while simultaneously selling another. It's similar to exchanging money for a stock – but instead of getting shares, you're getting an equivalent amount of another currency.

Say, for instance, that you have AU$1,000. You believe that the Australian dollar is going to fall in value against the US dollar, so you decide to use your Australian dollars to buy US dollars. The exchange rate between AUD and USD means you get $720USD for your AU$1,000.

If AUD does fall against USD, then your $720USD will be worth more than AU$1,000. You can swap your US dollars back to Australian dollars, and keep the difference as profit.

In this example, we've traded the AUD/USD forex pair.

Each currency pair has a price, which tells you how much of the second currency you'll have to sell to buy one unit of the first.

The first currency in a pair is called the base. The second is the quote.

See more forex trading examples .


Ways to trade forex

There are a few different methods to take your position on the forex markets. Let’s take a look at how spot forex, FX CFDs and forex futures work.

Spot forex trading

Spot forex trading is the way of trading currencies that we’ve covered in our example above. You trade by buying and selling the currencies within the pair, exchanging USD for EUR if you’re buying Eurodollar or JPY for USD if you’re buying USD/JPY.

To close your position, you simply make the opposite trade to how you opened it. So, if you sold USD to buy EUR at the outset, you’d sell EUR to buy USD to close.

You go long on forex pairs by selling the quote currency to buy the base, which means you profit if your pair’s price increases. Or you can go short by buying the quote and selling the base, enabling you to make a profit if your pair’s price falls.

Learn more about how forex trading works with City Index.

Forex CFDs

Forex CFDs offer an alternative way to take your position on FX pairs. You don’t exchange currencies with CFDs – you trade a contract that entitles you to exchange the difference in an FX pair’s price from when you open your position to when you close it.

Say, for example, that you buy a EUR/USD CFD at 1.0047 and sell it at 1.0085. Your CFD entitles you to exchange the difference between 1.0085 and 1.0047 – a profit of 38 points. If EUR/USD fell instead, you’d make a loss.

You can also go short with CFDs, by selling them instead of buying them.

Learn more about trading forex CFDs  with City Index.

Forex futures

With forex futures, you agree to exchange a set amount of currency on a set date at a set price. You’re still trading pairs, but instead of taking delivery of currency on the ‘spot’ your trade is executed in the future.

Futures enable you to take a long-term view on currency pairs. And like spot markets and CFDs, you can use them to short currencies too.

With City Index, you can trade forward CFDs on forex. They also enable you to take a long-term view, but aren’t traded on futures exchanges.

Learn more about futures trading .

Forex trading terminology

Let’s cover some of the key concepts you’ll encounter when forex trading: pips, lots and leverage.

Pips

A pip is a single point of movement in a currency pair. For the majority of pairs, a pip is equal to a single-digit move in the fourth figure after the decimal point. If EUR/USD moves from 1.0005 to 1.0006, it has gained one pip.

The exception to this rule is any pair with JPY as the quote. The yen has a comparatively low value compared to other major currencies, so a pip of movement in JPY is calculated as the second digit after the decimal point.

Lots

Lots dictate how much you make for each pip of movement in an FX pair.

As we’ve seen, a pip isn’t really worth very much in real terms. If EUR/USD moves 100 pips, for example, it only increases by one euro cent. Because of this, most FX trades use ‘lots’, which are equal to 100,000 units of currency.

Buy a single lot of EUR/USD, and you’ll make $10 for each pip that the pair rises – and lose $10 for each pip it falls.

You can also trade mini and micro lots, which enable you to take smaller positions.

Leverage and margin

Lots enable you to make profits from the relatively minor moves that FX pairs make, but you might not want to tie up 100,000 units of currency every time you want to trade.

Leverage means you don’t have to. Instead, you deposit a fraction of your trade’s total value – known as your margin – in order to cover any losses it may incur.

Your profit or loss will still be based off the full value of your position, which means both are magnified when you trade using leverage. This makes leverage a powerful tool, but it also makes it risky – which is why risk management  is crucial.

Types of forex pairs

A forex pair is a combination of any two currencies. From EUR/USD (the euro and the dollar) to HUF/PLN (the Hungarian forint and the Polish złoty), there are hundreds of potential pairs to trade.

But to keep things simple, pairs are typically split into three categories: majors, minors and exotics.

Major forex pairs

The major pairs are EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF and USD/CAD.  

Notice something about all the pairs above? They all contain the US dollar. According to the Bank for International Settlements, USD is present in 88% of all FX trades – mostly focusing on the majors.

EUR/USD, the combination of two of the biggest economies in the world – the eurozone and the United States – is the biggest major, representing around 28% of all trading.

Pair Currencies Nickname
EUR/USD Euro vs US dollar Eurodollar
USD/JPY US dollar vs Japanese yen Dollar-yen
GBP/USD Pound sterling vs US dollar Cable
AUD/USD Australian dollar vs US dollar Aussie
USD/CHF US dollar vs Swiss franc Swissy
USD/CAD US dollar vs Canadian dollar Loonie

Minor forex pairs

The minor pairs consist of all the currencies listed above, but crossed with each other instead of USD. EUR/GBP, AUD/NZD and EUR/CHF are all minor pairs. 

As these pairs don't contain the dollar, they tend to be a little bit less liquid than the majors. So you might find that spreads are wider.

Pair Currencies
EUR/GBP Euro vs Pound sterling
AUD/JPY Australian dollar vs Japanese yen
GBP/CHF Pound sterling vs Swiss Franc
AUD/NZD Australian dollar vs NZ dollar
EUR/CHF Euro vs Swiss franc
AUD/CAD Australian dollar vs Canadian dollar

Exotic forex pairs

Finally, you have the exotic pairs. Essentially, any pair containing a currency that isn't one of the majors, such as USD/PLN (US dollar vs Polish złoty), EUR/TRY (euro vs Turkish lira) and USD/ZAR (US dollar vs South African rand).

Benefits of forex trading

  1. Size

  2. As we’ve covered, the forex market dwarfs every other asset class. Because of this, it is highly liquid. That means there are lots of other traders trying to buy and sell currencies at any one time – so there’s usually someone available to take the other side of any deal.

    This ensures that prices are constantly moving, and helps keep forex trading cost effective.

  3. 24-hour trading

  4. Forex isn’t bought and sold on exchanges, like stocks or futures. Instead, a network of banks and businesses around the world facilitate trading. These banks and businesses don’t have to stick with an exchange’s opening hours, enabling you to buy and sell currency pairs 24 hours a day from Monday to Friday.

    For traders who value flexibility, this is a key benefit. You’re not confined to the specific hours of a stock exchange – you make your strategy work around your schedule instead.

    Learn more about the best times to trade forex.

  5. Going short

  6. With hundreds of markets constantly on the move, opportunities abound in forex. And that’s before you consider that any pair can be sold (going short) as well as bought (going long). 

    If you think that any pair is in for a rough ride, you can short it and attempt to profit from the move. Remember, though, that you'll earn a loss if the currency moves up instead of down.

Risks of trading forex

  1. Leverage

  2. As we note above, leverage magnifies both your profits and losses, which can make forex trading risky.

    Say, for example, that you trade one lot of EUR/USD at 1.0000. Your trade is worth $100,000, but you might only need $5,000 (converted into your base currency) in your account as margin to open it.

    If EUR/USD rises to 1.0100, then you make (100 pips x $10) $1,000 profit – a return of 20% from your leveraged trade, compared to just 1% if you had to put up its full value upfront. If Eurodollar falls to 0.9900, though, then the same effect applies to your losses – you lose $1,000, 20% of your original deposit.

  3. Volatility

  4. Forex markets can be highly volatile, especially outside of the majors. For many traders, this is a powerful benefit, but volatility brings risk as well as opportunity.

    When a market is highly volatile, losses on positions can add up quickly – particularly if you don’t have a stop-loss order attached to your position. Volatility combined with low liquidity can also lead to slippage, where your orders don’t execute at the price you requested.

  5. 24-hour trading

  6. Forex markets are always moving, even when you’re not monitoring the markets. That isn’t a problem if you’re always closing your trades at the end of each trading session, but can be if you’re pursuing a longer-term strategy.

    An AUD/USD trade, for example, could lose you significant capital if left open while you’re asleep. Waking up to a trade in the red can be a nasty start to the day.

    However, there are tools that can help you keep on top of trades when you’re not actively trading: including stops , alerts  and mobile trading apps . Learn all about the risks of forex trading and how to mitigate them.

Learn how to trade currency rates

If you’re looking for more information on how the financial markets work – including in-depth lessons on forex trading – head over to the City Index Academy . You’ll find step-by-step courses on how to trade, techniques of successful traders, how master forex and more.

Here are a few lessons you might be interested in:

  • Introduction to financial markets . An overview of all the asset classes you can trade, plus a few key concepts you should know
  • Advanced trading strategies. How should you target profit from FX markets?

Forex trading examples

Finally, here are a couple of in-depth forex examples to see how this works in practice. You can follow along with these examples using a free City Index demo account.

  1. Buying EUR/USD

  2. You buy one lot of EUR/USD at 1.1907. This is the equivalent of selling $119,070 to buy €100,000.

    EUR/USD has a margin requirement of 3.33%, so you’ll need $3965 (3.33% * $119,070) in your account to open the trade.

    The City Index platform will automatically convert your margin requirement into your account currency.

    The pair rises 82 points to 1.1989, and you close your position. Your €100,000 is now worth $119,890, a profit of ($119,890 - $119,070) $820.

    If EUR/USD fell 82 points, though, you’d lose $820.

  3. Selling USD/CHF

  4. You sell one mini lot of USD/CHF at 0.9198. A mini lot is equivalent to trading 10,000 units of the base currency instead of 100,000. Here, you’re selling $10,000 by buying CHF 9198.

    USD/CHF also has a margin requirement of 3.33%. This time, you’ll only need CHF 306 (3.33% * CHF 9198) in your account to open the position.

    The pair falls 70 points to 0.9128. Your mini lot earns you 1 franc for every point that it falls, giving you a total profit of (70 * 1) 70 francs.

    If the pair had risen instead, you’d make a loss.


What moves the forex markets?

Here are a few factors that often move currency markets:


Economic data

Traders will often flock to currencies backed by strong economies, increasing demand.

Inflation, unemployment numbers, payrolls or other key economic data can often have a major impact on forex prices.


Central banks

Central banks buy and sell large amounts of their own currency, attempting to keep it within a certain level.

They also set interest rates and dictate money flow, which will have a big influence on exchange rates.


Politics

The role of politics in driving currency markets has only grown in recent years.

Political uncertainty, for instance, can make ‘safer’ markets such as the Swiss franc and US dollar more attractive.

What is forex trading FAQs

How much money is traded on forex daily?

The average daily volume for forex trading is $6 trillion according the Bank for International Settlements, making it the largest financial market on the planet by some distance. This brings several benefits for FX traders , including high liquidity.

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What is forex short for?

Forex is an abbreviation of ‘foreign exchange’ the name for the marketplace in which individuals can buy and sell world currencies. It’s how individuals, businesses, central banks, and governments pay for goods and services in other countries.

Trading the forex market allows you to speculate on price movements in these currencies. Learn what forex trading is and how it works.

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Is forex trading profitable?

Forex trading can be profitable, if you’re able to open positions in the correct direction of trends and choose your trades correctly. However, it requires careful planning and risk management – and not every trader will make money.

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How do I start trading forex?

  1. Select a currency pair. When trading forex you are exchanging the value of one currency for another, so you’ll always be trading currencies in a pair
  2. Analyse the market. Research and technical analysis should inform every trade you make
  3. Read the quote. Understand the difference between the buy price and the sell price – known as the spread
  4. Open your position. When you trade forex, you can take both long and short positions, speculating on rising and falling market prices
  5. Monitor and close your position. Keep an eye on your profit or loss, and close your position when you’re ready

Start trading forex today.

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What are the major forex pairs?

The major pairs are the four most heavily traded currency pairs on the forex market. Currently, this is the EUR/USD, USD/JPY, GBP/USD, USD/CHF. The major pairs make up the vast amount of forex trades.

Learn more about the types of forex pairs.

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