What is forex trading – and how does it work?

Forex trading is the buying and selling of currency pairs like EUR/USD, GBP/USD and USD/JPY. It works across a vast network of global banks, which means you can trade FX 24 hours a day.

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.

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 to buy shares – but instead of getting shares, you're getting an equivalent amount of another currency.

Say, for instance, that you have £1000. You believe that the pound is going to fall in value against the euro, so you decide to use your pounds to buy euros. The exchange rate between GBP and EUR means you get €1163 for your €1000.

If GBP does fall against EUR, then your €1163 will be worth more than £1000. You can swap your euros back to pounds, and keep the difference as profit.

In this example, we've traded the EUR/GBP 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, EUR/GBP is trading at 0.8600. It costs 0.8600 GBP (the quote currency) to buy one unit of EUR (the base).

Our £1000 buys (1000 / 0.8600) €1163.

If EUR/GBP rises to 0.8700, then EUR is worth more in GBP. We can sell our €1163 for (1163 * 0.8700) £1,011, an £11 profit.

If EUR/GBP falls to 0.8500 instead, our €1163 is only worth (1163 * 0.8500) £989, an £11 loss.

Essentially, we've used our GBP to buy the EUR/GBP 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 and spread betting, you’re speculating on the movements of pairs without buying or selling the currencies themselves.

Learn more about how to trade forex.

Benefits of forex trading

1. Size

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 make a loss if the currency pair moves up instead of down.

4. Leverage

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.

Types of forex 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 dozens of potential pairs to trade.

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

Majors

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

Minors

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.

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

Exotics

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 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. Or if you’re spread betting forex, you don’t need to convert any currencies at all.

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 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.

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) $75,208. 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 $75,208, 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.

You can learn more about managing forex risks here.

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:

What is forex trading FAQ

What is forex?

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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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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