Forex Trading

Forex trading is the process of swapping one foreign currency for another. Given the interconnectedness of the global economy, these financial transactions are extremely common. Currency trading facilitates international trade, tourism and the flow of capital and also allows institutional and retail investors to engage in speculation or hedging strategies to control their level of risk.

Thomas Brock, CFA, CPA, expert contributor to Annuity.org
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APA Brock, T. J. (2022, June 13). Forex Trading. Annuity.org. Retrieved June 26, 2022, from https://www.annuity.org/personal-finance/investing/forex/

MLA Brock, Thomas J. "Forex Trading." Annuity.org, 13 Jun 2022, https://www.annuity.org/personal-finance/investing/forex/.

Chicago Brock, Thomas J. "Forex Trading." Annuity.org. Last modified June 13, 2022. https://www.annuity.org/personal-finance/investing/forex/.

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What Is Forex Trading?

Forex trading, which is short for foreign exchange trading, is the act of swapping one sovereign currency (such as the U.S. dollar) for another (such as the Japanese yen). The process of trading foreign currency is conducted for many reasons, but it is most commonly done to facilitate international trade, tourism and capital flows and for investors to engage in speculation or hedging strategies to offset the risks associated with investing.

Generally, any currency can be exchanged for another, and when two currencies are quoted for an exchange, they are referred to as a currency pair. The quoting process results in a forex rate — an expression of the value of the first currency in relation to the second.

Simple Example of Forex Trading

Suppose you operate a small business in the United States and want to buy $10,000.00 of computing equipment from a company in South Korea. In this scenario, you must buy the equipment with South Korean won (SKW), not United States dollars (USD). This means you must exchange $10,000 into the equivalent amount of won to execute the transaction.

In this example, if the current exchange rate for 1.00 USD were 1,260.00 SKW, you would need to exchange $10,000.00 for 12,600,000.00 SKW to facilitate the deal.

Exchange Value Example

What is the Foreign Exchange Market?

With an estimated daily trading volume of more than $6 trillion and nearly 14 million total traders, the foreign exchange market is the largest, most liquid market in the financial world. Operating on a decentralized basis 24 hours a day, five-and-a-half days a week, the market consists of a massive electronic network of banks, brokers and traders. The foreign exchange market covers a wide range of currencies, including the United States dollar, the British pound sterling, the Canadian dollar, the Japanese yen and the eurozone euro, to name a few.

Note: The majority of forex trading is conducted virtually, but many physical exchange points do exist. They are most common in densely populated areas of developed and emerging markets.

Pros and Cons of Forex Trading

As the largest and most liquid financial market in the world, the forex market is a vital venue for institutional and retail investors who are focused on generating wealth and hedging currency risk. That said, the forex market is complicated, with many pros and cons. The chart below highlights the most important considerations about forex trading.

Pros
  • The market is highly liquid, with trading conducted 24 hours a day, 5.5 days a week
  • It operates via a global, electronic network of banks, brokers and traders; the largest hubs are in Frankfurt, Hong Kong, London, New York, Paris, Singapore, Sydney, Tokyo and Zurich
  • The decentralized nature of forex largely eliminates the potential for the type of market manipulation and insider trading that exists in public stock markets
  • The use of leverage in forex trading allows you to minimize capital outlays and amplify profits
  • Forex trading can mitigate existing foreign currency exposures
Cons
  • Foreign currencies, especially those in emerging markets, can exhibit a high degree of volatility
  • Successfully trading forex requires a sophisticated understanding of financial concepts and economic fundamentals, knowledge of international trade, and an awareness of geopolitical developments
  • The decentralized nature of forex makes it less regulated than other financial markets; trading safeguards vary widely across the globe
  • The use of leverage can magnify losses and lead to the insolvency of both dealers and traders
  • Forex trading can expose you to foreign currency risk

How Do You Start Trading Forex?

The forex market is influenced by many macroeconomic factors and is highly sensitive to technical imbalances of supply and demand. As a result, currencies, especially the currencies of emerging markets, can demonstrate a high degree of volatility.

If you are considering getting into forex trading, the first step is to educate yourself on the market and its operations. You should begin with a basic understanding of key forex terminology. To accelerate your education, check out one of the many online courses designed to teach beginners the basics of forex trading.

Next, you need to open a brokerage account. Opening an account is relatively simple and can be done online in less than 15 minutes. Funding a new account can take a bit longer, but you can be ready to trade in a matter of days. One important consideration when opening an account is the lot size (the standardized size of a trade) at which you intend to trade. Basically, there are three types of forex accounts, which can be summarized as follows.

  1. A standard forex account allows you to trade 100,000 units of a currency in one lot.
  2. A mini forex account allows you to trade 10,000 units of a currency in one lot.
  3. A micro forex account allows you to trade 1,000 units of a currency in one lot.

For beginners, the micro account is usually the best option, given its relatively low lot size.

Once you’ve established a brokerage account, you need to develop a trading strategy. This involves establishing some qualitative principles and quantitative rules to guide your day-to-day behavior. The strategy should be based on your financial position and your tolerance for risk. This means looking at your personal finance situation and identifying the amount of cash you are willing and able to risk, the extent to which you intend to utilize financial leverage and the points at which you are committed to realizing your gains and losses.

Long vs. Short Positions

Ultimately, a forex trade is characterized as either a long trade or a short trade. With a long trade, there is an expectation that a purchased currency will increase in price, which will generate an economic gain for the buyer.

With a short trade, a sold currency is expected to experience a price decline, which generates a gain for the seller. Essentially, a short trade involves the following steps:

  • Establish a future-dated contract to sell a currency at a price you believe to be overvalued and likely to decline.
  • If your forecast is accurate, the currency’s price will fall.
  • Then, on the contract settlement date, a profit can be realized by buying the currency at its current price, delivering it to settle the contract and netting the difference between the inflated contract value and the lower market price.

What Are Some Basic Forex Trading Strategies?

Currencies can be traded in three venues: the spot market, the forward market and the futures market. The spot market is the largest of the three. It’s where currencies are bought and sold immediately, based on their current, on-the-spot prices.

The forward and futures markets consist of contracts that are based on the spot market. Because the buy- and sell-side values of the contracts are derived from the spot market, the forward and futures markets are known as derivatives.

A forward contract is a private, customized agreement between two parties to exchange currencies at a future date at a predetermined price. A futures contract is a standardized agreement between two parties to exchange currencies at a future date at a predetermined price.

Forward contracts are traded over-the-counter, while futures contracts are traded on exchanges. Forwards are largely unregulated, uniquely structured and subject to a high degree of counterparty credit risk. Conversely, futures are highly regulated, at least in developed nations, standardized (in terms of their position size, delivery and settlement dates) and protected from counterparty credit risk.

Note: The spot market reflects the exchange rate at which a foreign currency can be bought or sold today. The forward and futures markets, which are often used to hedge foreign currency risk, reflect the exchange rate at which a foreign currency can be bought or sold in the future.

Frequently Asked Questions

Why do people trade forex?
Forex traders fall into one of two groups: speculative traders or risk-hedging traders. Speculative traders are typically opportunistic and are looking to make a profit from the movement of currency prices. Risk-hedging traders are more defensive and seek to mitigate existing exposures to currency risk.
What are the most commonly traded currency pairs?
The forex market is a high-traffic and dynamic environment, with money constantly flowing into and out of many currencies. The most commonly traded currency pairs are outlined below. According to the Bank for International Settlements, these commonly traded currency pairs make up over 70% of forex trading volume.
  • EUR/USD (euro/U.S. dollar)
  • USD/JPY (U.S. dollar/Japanese yen)
  • GBP/USD (British pound sterling/U.S. dollar)
  • AUD/USD (Australian dollar/U.S. dollar)
  • USD/CAD (U.S. dollar/Canadian dollar)
  • USD/CNY (U.S. dollar/Chinese renminbi)
  • USD/CHF (U.S. dollar/Swiss franc)
  • USD/HKD (U.S. dollar/Hong Kong dollar)
  • EUR/GBP (euro/British pound sterling)
  • USD/KRW (U.S. dollar/South Korean won)
Are forex markets regulated in the U.S.?
The United States maintains a sophisticated regulatory framework for forex markets. Oversight is maintained by the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA) and the U.S. Securities and Exchange Commission (SEC)
What is the bid-ask spread?
As with other financial assets, currency exchange rates are determined based on the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers require to sell a currency (the ask). Generally, the ask is higher than bid, and the difference between the two is known as the spread. Essentially, the spread is the compensation earned by a forex trader. It can fluctuate, depending on market conditions and the size of a trade.
What is a pip?
A pip, which is short for price interest point, is the minimum price movement measured for a currency. A pip goes out to four decimal points. So, one pip is equal to 0.0001. In terms of the United States dollar, one pip equals $0.0001, one hundred pips equal $0.01 and 10,000 pips equal $1.00.
How do you avoid forex scams?
According to the SEC, retail investors need to be wary of “get rich quick” investment schemes that promise significant returns with minimal risk through forex trading. Fraud is very common in forex trading, especially in unregulated foreign nations. Contact the appropriate federal regulator for information about firms and individuals of interest. You can verify CFTC registration and NFA membership status and check disciplinary history by calling the NFA at 800-621-3570. You can also research specific firms and brokers on the NFA’s Background Affiliation Status Information Center website.
Please seek the advice of a qualified professional before making financial decisions.
Last Modified: June 13, 2022

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