Introduction to financial markets
It’s time to get to grips with the fundamentals of the forex market – one of the biggest financial markets on the planet.
- What is forex?
- What is forex trading?
- Benefits of forex trading
- Types of currency pair
- Forex trading examples
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 pounds 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 $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 US$1,000. You believe that the US dollar is going to fall in value against the Australian dollar, so you decide to use your US dollars to buy Australian dollars. The exchange rate between AUD and USD means you get AU$1,333 for your US$1,000.
If USD does fall against AUD, then your AU$1,333 will be worth more than US$1,000. You can then swap your Australian dollars back to US 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.
Forex trading example: EUR/GBP
Let’s take a closer look our example above. Here, AUD/USD is trading at 0.7500. It costs 0.7500 USD (the quote currency) to buy one unit of AUD (the base).
Our US$1000 buys (1,000 / 0.7500) AU$1,333.
If AUD/USD rises to 0.8000, then AUD is worth more in USD. We can sell our AU$1,333 for ($1,333 * 0.8000) US$1,066, a US$66 profit.
If AUD/USD falls to 0.7000 instead, our AU$1,333 is only worth (1,333 * 0.7000) US$933, a US$67 loss.
Essentially, we've used our USD to buy the AUD/USD pair. If its price goes up, we make a profit. If it falls, we make a loss.
Did you know? You don’t have to exchange currencies to trade forex. With derivatives such as CFDs, you’re speculating on the movements of pairs without buying or selling the currencies themselves.
Benefits of forex trading
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.
2. 24-hour trading
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.
3. Going short
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).
When you short forex, you're using the base currency to purchase the quote. Instead of going long EUR/GBP by using GBP to buy EUR, you could go short EUR/GBP by using EUR to buy GBP. If the pair falls, your pounds are worth more in euros, earning you a profit.
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 pair moves up instead of down.
Forex moves in pips.
Each pip is worth 0.01% of one unit of the base currency – if EUR/USD moves 100 pips, it only increases by one euro cent. To earn sizable profits, then, you have to trade a large amount of forex. A standard contract, called a lot, is worth 100,000 units of the base currency.
You won't have to put down that amount to trade forex, though, thanks to leverage. You only need a deposit in your account known as your margin. This makes forex trading flexible, but it can also make it risky.
Let's examine how.
Types of currency pair
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.
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 most popular major pair, representing around 28% of all trading.
|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|
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 slightly wider.
|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|
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).
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
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 5%, so you’ll need $5953.50 (5% * $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.
2. Selling USD/CHF
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 5%. This time, you’ll only need CHF 460 (5% * 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.
Forex trading risks
When you're trading forex, leverage will amplify both your profits and your losses.
Say you want to buy one standard lot of AUD/USD at 0.7520. In this transaction, you'd be selling (100,000 * 0.7520) $75,200. To open the position, you might only need 5% of its total value in your account, or $3760.
AUD/USD rises 100 pips to 0.7620, and you close your trade. You've made $1000 from an initial $3760. If you'd had to deposit the full $75,200, you'd still have made $1000, but by paying much more at outset. With leverage, your profits are magnified.
But what if AUD/USD falls 100 pips? You'd lose $1000 from your $3760, more than a quarter of your starting capital. Leverage has amplified your loss.
Because of this, effective risk management when trading currency rates is critical.