The Forex market is a global, decentralized market where currencies are traded. Unlike a stock market, for example, there is no central exchange or single entity that facilitates the exchange of currencies.
Forex trading is conducted over-the-counter (OTC) through a network of banks in various major financial centers around the world. Exchange rates change every second, as computer networks efficiently facilitate exchange rates.
The Forex market is active 24/5 due to the overlapping time zones of the four major financial centers:
New York – Tokyo – Sydney – London
How does Forex trading work?
Composition of Currency Pairs
Forex trading involves the simultaneous purchase of one currency and the sale of another, that is, the exchange of one currency for another.
When trading Forex, you’ll notice that prices are determined based on a currency pair, called the base and quote currencies—for example, the EUR/USD or GBP/USD currency pairs. The pair can also be represented by EUR/USD or GBP/USD.
Types of Currency Pairs
There are three main types of currency pairs traded in the Forex market:
Main – There are eight major currencies in the world. However, there are only seven major currency pairs. This is because the US dollar is the base or quote currency for all major currency pairs.
Minor Currencies – Minor currencies, also called cross pairs, are groups of major currencies that do not include the US dollar as the base or quote currency.
Exotics – Exotics are pairs composed of a major currency and a currency from an emerging market country.
Important Terms in Forex Trading
Here are some terms you should know when you start trading forex:
EUR USD represents the Euro/US Dollar currency pair.
The first currency (EUR) is the base currency.
The second currency (USD) is the quote currency.
Point – A point (or pip) is the smallest change in the price of a currency pair. If the price of EUR/USD moves from 1.0000 to 1.0001, it can be said to have changed by one pip.
Bid/Ask Price – There are always two prices offered, known as the forex quote:
The first value (1.0000) is the bid price. This is the price the broker will pay the seller for the base currency.
The second value (1.0003) is the ask price. This is the price at which the broker will sell the base currency. The bid price is always lower than the ask price.
Spread – The spread is the difference between the bid and ask prices. It represents the cost of Forex trading. In the example above, the spread is: 1.0003-1.0000=0.0003 or 3 pips.
Lot – A lot is a unit of measurement. Forex is traded in lot sizes such as Standard (100,000 units), Mini (10,000 units), Micro (1,000 units), and Nano (100 units).
Leverage – Leverage is similar to the lending facility offered by retail brokers, allowing traders to trade with much more capital than they have available. For example, with $1,000 in capital and 100:1 leverage, you can open trades worth $100,000. Margin – Margin is the amount of capital required to open a leveraged position in the market. As mentioned above (leverage), $1,000 is the margin required to open a $100,000 leveraged position in the market.
Margin Level – The margin level is the ratio between your account balance (equity) and the margin used. The higher the margin level, the healthier your account, and vice versa.
Position (Trade Position) – Once a trade is open and exposed to the market, it is defined as having a position. You will often see descriptions such as “open a position” or “sell a position.”
Key Players in the Forex Market
Major Banks – Large banks are at the top of the foreign exchange market. They participate in what is known as the interbank market, a global network used by banks to conduct large foreign exchange transactions with each other.
Multinational Corporations – Large multinational corporations are primarily operational participants, conducting transactions to facilitate their business. These multinational corporations typically conduct their transactions through large banks.
Central banks are influential players in the foreign exchange market, in keeping with their mission to ensure the stability of their national currencies and maintain foreign exchange reserves. Central banks can participate directly in foreign exchange markets by buying or selling currencies, or indirectly by adjusting interest rates or enacting regulations that affect the money supply.
Speculators – Speculators buy and sell currencies with the aim of making a profit. Speculators take advantage of exchange rate fluctuations to seek profitable opportunities. There are large speculators, such as hedge funds, and small speculators, such as retail traders like you.
Retail Forex Traders – Retail traders, also known as individual traders, trade Forex for their own personal account and not on behalf of any organization or institution. Retail traders are also speculators. Retail traders can access the global Forex markets through retail Forex brokers such as AvaTrade.
Retail Forex traders generally trade for two main reasons:
Speculation, in its simplest form, simply means buying low and selling high. The difference between the buy and sell prices is the profit or loss less any fees or commissions. Hedging – Hedging is a general term for specific trading strategies used to reduce unexpected market risks and potential losses.
Different Foreign Exchange Markets
There are several ways for traders (individuals and institutions) to participate in the Forex markets:
Spot Markets – A spot market is an over-the-counter market where two parties agree to exchange one currency for another at the current market price. When you trade Forex with AvaTrade, you will be trading Forex CFDs (Contracts for Difference) based on the spot market. A CFD specifies the quantity and price at which the transaction will take place.
Futures Market – The Forex futures market is also an over-the-counter market that allows two private parties to agree to exchange currencies at a future date and a predetermined price. You will not be trading in the futures market as a speculative retail trader.
Futures Market – The Forex futures market is centralized (not over-the-counter) and is traded on exchanges such as the CME (Chicago Mercantile Exchange). It allows the purchase and sale of standardized foreign exchange contracts that will be delivered at a future date and a predetermined price. Retail traders like you do not participate in the futures market.
Forex Options – Options refer to a contract that allows the buyer to buy or sell an underlying asset (in this case, currencies). Options differ from futures contracts in that the owner is not obligated to buy or sell the underlying asset. They must, however, exercise their option before the expiration date.
What Moves the Forex Markets?
Like any market, prices in the Forex markets are influenced by the forces of supply and demand. Here are some factors that can move the foreign exchange markets:
Central Banks – The actions of central banks have a significant impact on exchange rates. Events such as interest rate increases or decreases, quantitative easing, and tightening can affect values in the foreign exchange markets. Economic News – Press releases are the main catalysts for major price movements in the forex market, such as central bank updates, employment and inflation data, CPI and GDP data, manufacturing data, and more. Be sure to use AvaTrade’s free economic calendar tool.
Market Sentiment – Sentiment is a measure of what the majority of market participants think about the market. The market can be bullish, bearish, or neutral at any given time.
Why Trade Forex?
Pros
High Liquidity – Forex is the world’s largest financial market, making it highly liquid. This means you can buy and sell easily, as well as trade with tight spreads.
24-Hour Market – Money never sleeps in the market. You can search for Forex trading opportunities 24 hours a day, from the Asian market session opening Sunday night until the New York close late Friday night.
Leverage – You can open much larger trades with less capital to realize a greater profit. Leverage can also be a disadvantage (see the negatives below).
Decentralized Market – No single entity can control or monopolize the vast global foreign exchange markets.
Low Trading Costs – You only pay the spread – no additional commissions, such as brokerage fees or other unnecessary charges.
Simplicity – Buy, sell, hedge, or implement the trading strategy of your choice.
Disadvantages
Risks of Leverage – Leverage is a double-edged sword. It can magnify losses on trades that go against your expectations. AvaTrade offers flexible leverage options tailored to your risk profile and negative balance protection to reduce risk and potential losses.
Market Risks – Forex markets can sometimes be highly volatile with significant price movements, especially during high-impact data releases, major global events such as the outbreak of war, financial market crashes, etc. AvaProtect is an innovative risk management feature from AvaTrade that offers protection against losses of up to $1 million.