What is Forex and How Does It Work?

How forex works

The key thing traders need to keep in mind when trading forex is that currency prices are constantly changing. For example, right now the euro is 1.7 dollars, but in an hour, it might drop to 1.69.

The value of one currency expressed in another is called a quote. Each quote appears on the chart in the trading platform and marks a point. This point is automatically connected to the previous price level and creates a price chart in real time. Traders sit in front of their monitors or smartphones, and watch the chart change to decide what is the best time to trade.

We've already mentioned a common modern solution when trading forex is leverage. This means that when you open a trade, the broker adds their own funds to your investment. The amount of leverage can vary from 1:1 (where you only trade with your own money) to 1:500 (where for every dollar you put in, the broker adds 500 more).

This means that with relatively small capital, starting from as little as $100, you can enter the global forex market and trade sums starting at $10 000.

How does the forex market work?

A trader buys a currency at one price, and sells it for a higher price, gaining a profit. Is it really that simple?

The forex market differs from other markets, such as stock markets, which are located in physical exchanges like the New York Stock Exchange. The forex market is decentralized, and all the trading happens through a broker-dealer network. Forex buyers and sellers practice over-the-counter trading (OTC): they make trades directly, usually through banks, brokers, or online platforms.

Many factors affect currency rates. Here are the most important ones.

1. Suppose a country’s central bank raises interest rates. Its currency then usually strengthens, because higher rates attract more investors (and vice versa).

2. The economic situation — unemployment, inflation rate, and economic growth — always influences a currency’s value. Usually, and unsurprisingly, strong economic growth makes a country’s currency more valuable and vice versa.

3. The political situation is another essential factor. In times of political instability or military conflicts, the value of a currency can go down.

4. However, not all factors are on a planetary scale. In addition to the impact world events can have on exchange rates, people’s emotions play an important role, too. The factor called market sentiment measures how traders feel about a currency’s future. If they are optimistic, this indicator can drive the currency’s value higher.

Who trades currencies?

Nowadays, anyone can trade forex. You have likely done it yourself, for example, on a trip overseas when you needed to buy or sell things with a local currency. Simply exchanging money — that is forex. When a company buys or sells to a party abroad, they need to change currencies on a daily basis to operate successfully.

So who are the major players in the forex market?

• Large banks are a big part of the forex market. They trade currencies for themselves, and on behalf of their clients, which include large businesses and governments.

• Central banks also participate in currency trading. This helps them manage exchange rates and maintain economic stability in their countries

• Governments may also take part in the forex market as a way to manage their FX reserves, or to impact the value of their country’s currency.

• Major corporations trading internationally often need to exchange currencies daily to operate successfully.

• Large financial firms, like hedge funds or mutual funds, trade currencies as part of their investment strategies. They make profits from changes in exchange rates.

Some people trade for a living. They can work for individual clients, for a financial organization like a hedge fund, or just be self-employed. Individual investors often use online platforms to trade currencies.

A forex trader is someone comfortable operating with large amounts of information. A successful foreign exchange investor should be able to work with a lot of different indicators and carry out complex analyses.

In the past, only large companies could trade in the forex market, but now anyone can do it, including you.

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Types of currency pairs

To make money by trading forex, you need a pair of currencies.

The currencies usually have a specific three-letter name, like JPY — the Japanese yen. The first two letters represent the country’s name (Japan), and the last one stands for the name of the currency (yen). These three-letter names are called ISO 4217 Currency Codes. They are used not only in trading, but also on plane or train tickets, for example.

Forex pairs are written like this: GBPUSD (or GBP/USD). The first currency in a written pair represents the base, or the currency being sold; the second one is the quote, or the currency being used to pay for the base. The goal of trading forex is to profit from shifts in the exchange rate — the price in the quote currency of a unit of the base currency.

Types of currency pairs

What are the types of currency pairs? There are:

• major;

• minor;

• exotic;

• triangular;

• commodity pairs.

Major and minor currency pairs

Major currency pairs are the most popular on the market. They are frequently traded and include the world’s most stable currencies. Note that major pairs include USD. Unlike minor pairs, they have high liquidity, tight spreads, and lower volatility. Common major pairs are:

• EURUSD: the euro vs the US dollar;

• USDJPY: the US dollar and the Japanese yen;

• GBPUSD: the British pound vs the US dollar;

• USDCHF: the US dollar vs the Swiss franc;

• AUDUSD: the Australian dollar vs the US dollar;

• USDCAD: the US dollar vs the Canadian dollar;

• NZDUSD: the New Zealand dollar vs the US dollar.

Minor ones do not include the USD. They are also called "cross-currency pairs". They are less liquid, and therefore have wider spreads and higher volatility. Here are some common minor pairs:

• EURGBP: the euro vs the British pound;

• EURJPY: the euro vs the Japanese yen;

• GBPJPY: the British Pound vs the Japanese yen;

• AUDNZD: the Australian Dollar vs the New Zealand dollar;

• EURAUD: the euro vs the Australian dollar.

Some popular pairs are known by nicknames on the FX market. For example, EURUSD is Fiber, AUDUSD is Aussie, USDJPY is Gopher, and GBPUSD is Cable. It is handy to learn forex slang, and be cautious before you start using it — make sure you avoid misunderstanding and confusion.

Unsure which pairs to trade first? All about the best currency pairs for beginners in this FBS article.

Exotic and other types of currency pairs

An exotic pair is one in which a major currency is paired with that of an emerging or smaller economy. They are usually less liquid and more volatile, and their spreads are wider compared to major and minor pairs. Political instability and economic events can influence their trade. Also, they usually have lower trading volumes.

Triangular pairs involve three different currencies. Commodity pairs consist of currencies from countries exporting commodities. Their values often change with the price of the commodities. Take AUDUSD, for instance: the Australian dollar is linked not only to the US dollar, but also to gold.

Trading triangular or commodity pairs is more complex and requires a lot of experience.

How to start trading forex

A beginner’s glossary

Before diving into the world of currency trading, get acquainted with some common terms you will need. This will help you understand the trends and the market better.

• An exchange rate is the price of a unit of one currency in another. This can be constantly shifting, determined by the market, or fixed — set by a central bank and not changing.

• Pip is short for percentage in points. It is one-hundredth of 1% and appears as the fourth decimal place (0.0001). Changes in the exchange rate are measured in pips. For example, if USD/CAD moves from 1.1050 to 1.1051, that is a change of one pip.

• Margin is how much money you need to put into your account to open a trade with leverage.

• Leverage — if you do not have a lot of money to deposit, leverage can help you out. Leverage is borrowing money from a broker. That means you can trade with 50 times more money than you actually have. It is an invaluable instrument, but it also comes with higher risks.

• The bid price is the buying price — the most a buyer can pay.

• The ask price is the lowest a seller can accept — the selling price.

• Spread is the difference between the previous two: the bid and the ask price. For example, the bid price is $40 and the ask price is $43, so the spread is $3.

• Support is a price level at which traders tend to buy. The price usually doesn’t continue to go down after reaching this level on a downtrend.

• Resistance is the opposite of support. At this level the prices are likely to fall.

• Slippage (gapping) — sometimes there is a time gap between the moment when an investor places the trade and the moment at which the trade actually happens. The price can change in this gap — that is slippage.

• A stop-loss order automatically closes the trade when a security reaches a particular price. This is a useful risk management instrument that can help you limit potential losses.

• A trailing stop is a version of a stop-loss: when the price goes up, the stop goes up too, but if the price falls to a certain point, it closes the trade to protect your profit.

• A take-profit order works in reverse to a stop-loss. Set a price, and when the currency reaches it on an uptrend, the trade will close automatically.

• Bollinger bands show how the price is changing: if the price gets near the band, that means it is overbought or oversold. This is useful when traders try to predict the price changes.

• Moving averages are an analytical tool that helps traders understand the price trends.

• The relative strength index (RSI) can also indicate whether a currency is overbought or oversold.

First steps in forex trading

1. Learn as much as you can. Check out FBS Academy and FBS Glossary: learn the ropes of currency trading and major FX terms. It will make you more confident and help protect your assets.

2. Do market research. Pay attention to technical and fundamental analysis, study the charts and read analytical reports.

3. Develop the best trading strategy. Define your entries and exits, risk capital, maximum stop-loss and take-profit orders, margin and leverage.

4. Start a demo account at FBS: gain experience with virtual money in a safe way.

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Types of markets

The forex market consists of three:

• spot market;

• forwards market;

• futures market.

Each of them has its peculiar features and allows traders to trade currencies, speculate, and hedge in different ways.

The spot market

The spot market, or spot FX, is a currency exchange for a spot price (it is also called the current price) with immediate delivery. However, some assets also quote a futures or forward price. It is the most common and largest forex market in the world.

You can trade:

• currencies and currency futures;

• commodities (such as metals, energy, etc);

• securities;

• T-bills and bonds.

The spot market appeals to traders because it is highly active and liquid, offers immediate delivery, and provides traders with real-time prices. Often the spreads are smaller, so it costs less to open a position. There are 80+ currency pairs available to traders.

The spot market has its drawbacks as well: for example, it is not very suitable for hedging, and there is an overnight funding fee to keep your position open until the next day. Furthermore, like any other market, it is risky. You can lose more than you deposit due to the margin.

Forwards and futures markets

When a buyer and a seller sign a forward contract, they agree to exchange the currency at a future date with a price agreed upon today. These contracts often have more flexible conditions and can be customized. Forwards are common in hedging because they can lower the volatility of the price. Usually, the details of the contracts are kept between the parties.

The futures market involves buying and selling at a predetermined price, to be settled on a specified future date, so traders can bet on whether prices will go up or down. Daily changes in the market are reflected in the contract.

Key differences between forwards and futures are represented in the table below.

How forex is traded

The best time to trade: forex sessions

The currency exchange market is open day and night, but that doesn’t mean it’s active 24 hours a day. There are four main trading sessions named after the major financial centers:

1. The Sydney session (10 p.m. – 7 a.m. GMT): relatively calm trading with lower volatility, although AUD, NZD, and JPY are exchanged actively.

2. The Tokyo session (12 a.m. – 9 a.m. GMT) is linked to the Asian markets. Investors trade pairs including the Japanese yen most actively during this time.

3. The London session (8 a.m. – 5 p.m. GMT) is highly liquid. London is the main financial hub in the world, so this session is a huge part of the global market. The most traded currencies are the British pound, the euro, and the Swiss franc.

4. The New York session (1 p.m. – 10 p.m. GMT) is very active, on a par with the London session. Most of the major political and economic events you hear about in the news generally concern this session, as it is the period when the world’s main reserve currency, the USD, is in high volatility.

In choosing when to trade, opt for when the market is most active: when there are numerous positions opening and closing, the trading volume is high. During these active hours, the spreads are smaller and there is a lower chance of slippage.

Trading platforms

In the forex market, everything happens online. A must-do for any trader is to choose a convenient and reliable trading platform — software developed to provide traders with necessary and practical information. Trading platforms show charts where you can track how a currency’s value has moved over time, and offer data that helps predict future price changes. You can place different types of orders and use algorithmic trading. There is a variety of risk-management tools. Also, they allow you to trade on the go. MetaTrader 4 and 5 are well-known and popular nowadays.

Risk management techniques

The forex market changes quickly and can be very unpredictable. Setting rules that will protect your money and prevent losses is highly important.

• Prepare a good trading plan. A plan will keep you disciplined and motivated. The plan should serve your goals and take into consideration all the circumstances that are crucial to you.

• Start with a demo account. Practice and learn risk-free before opening real trades.

• Use position sizing — the amount of money within the portfolio a trader is going to invest.

• Use the right risk-to-reward ratio. The most common is 1:3, meaning for every $1 you put into trade, you try to make $3.

• Diversify your investments. Do not put all your money into one trade or just one currency pair, split the money between several trades. That way, if you lose on one trade, you will not lose all your money.

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How is forex used for hedging?

Hedging is another strategy individual traders and companies use to manage risks. It’s like a backup plan for your money. As the forex market is very volatile, they want to protect their wealth from losses that can come with currency fluctuations.

So what is hedging in simple words?

For example, you expect that the currency price will go up, but you are not 100% sure. So, to protect yourself if the price goes down, you make the opposite bet. This way, if your first plan does not work out, the second one can help you not lose as much. However, risk reduction always goes hand in hand with a reduction in the expected profit.

Corporations, exporters and importers, investors, and individuals can all use hedging in forex markets.

There are financial instruments that can help investors hedge against currency risk.

• Forward contracts. They help secure exchange rates.

• Futures contracts. Futures are standardized, which increases their liquidity, but they offer less flexibility than forwards.

• Currency options. An options holder can (but does not have to) trade FX at an agreed rate before a set expiration date. This gives more flexibility while still providing protection.

• Currency swaps. A swap is a currency exchange with another party, but the parties reverse the transaction at a later date. Swaps are useful when companies want to manage longer-term currency exposure.

Pros and cons of trading forex

Let’s take a look at the pros of trading forex that make it appealing for investors all over the world.

1. Forex is open 24 hours a day, five days a week, except weekends. You can trade at almost any time, which is convenient for people with different schedules.

2. Forex is highly liquid. According to experts, the daily volume of the FX market is about $2.4 quadrillion. You can buy and sell currencies quickly, often without major price swings. For example, if you trade a major currency pair like EURUSD, it’s usually easy to find a buyer or seller right away.

3. There are relatively lower transaction costs (commission and brokerage) in the forex market than in other markets like stocks. The majority of FX brokers make their money from spreads, not from fees.

4. With leverage you can put more money into the trade than you have. For example, with 1:30 leverage, you can use $3000 while investing just $100 of your own money. This can greatly increase your potential profits if the market moves in your favor.

5. You can make a profit in rising or falling markets. If you think a currency value will go up, you can buy it (go long). If, on the contrary, you expect it to fall, you can sell it (go short). This gives a trader more opportunities for growth, compared to markets where you can only profit when prices rise.

6. The FX market offers a wide choice of pairs to trade. With more than 25 major currency pairs to choose from, you are maximally flexible and can switch easily from one to another if needed.

7. Although the forex market is known for its volatility, that can be an advantage for you. If a trade is placed carefully, swift price changes give an opportunity to make a great profit.

8. Forex trading is accessible to people of all skill levels. There are plenty of technical indicators and analytical strategies to help you start successful trading.

However, the perks always come with some disadvantages, and forex trading is no exception.

1. Any kind of trading involves a high risk of losses. For a forex example, leverage can skyrocket the profits, but it can also magnify the losses. A small price change can lead to large losses. Having a risk management strategy is essential so you do not lose more money than you invested.

2. High volatility can be your enemy: currency prices often change unexpectedly and rapidly. Sometimes it is hard for traders to predict what will happen next. Even small news events or political changes can cause prices to rise or fall significantly, so inexperienced traders should be very careful.

3. As we mentioned before, forex operates 24/5. It demands constant attention and monitoring. It can be stressful: a trader can miss opportunities because they did not react promptly to market changes.

4. The forex market is demanding. A trader who wants to do well in the market should have a thorough understanding of economics and the factors that impact it. It can feel quite overwhelming, especially for those just starting out.

5. The FX market is not entirely transparent. You may not see all the details of how your trade order is made, or may not get the best price. Work with regulated brokers so your money is protected.

6. Unlike stock traders, a FX trader should rely only on themselves when learning the process — there is usually no help or assistance. Patience and persistence while self-learning will get you to your goal.

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Forex scams: everything you need to know

What are the most common forex scams?

The forex market is large, which makes it not only a great option for both experienced investors and beginners, but also a target for scammers. Thousands of traders suffer from the unethical actions of dishonest brokers each year. Fortunately, knowing how to discern fraud from a reliable broker will help you avoid scams. The first important step is identifying a scam. The majority of forex scams are usually not transparent, share promises of high profits with little risk, and include aggressive selling and unsolicited offers.

Here are some of the most common forex scams to watch out for.

1. Signal sellers. A signal is some information that a broker offers to a trader. These prompts are supposed to give the trader an advantage and secure a successful deal, so the broker charges a fee for this information. Be cautious — yes, certain data can indeed give valuable insight and boost your chance of a successful trade, but nobody can guarantee a profitable trade. Signal sellers usually go back on their promises as soon as they get their fee.

2. The point-spread scam. Brokers make a profit from spread, and the bigger it is, the more they earn. So dishonest brokers meddle with the programs that display the prices and widen the gap between the bid and the ask. Protect yourself from this scheme by asking reputable brokers about the spread. However, sometimes a slippage can occur. You can make a stop-loss order to protect yourself from losses in case this happens.

3. Automation scam. Some brokers offer to automate trading using software so you can technically trade when you are not online. However, it is not always clear how these robots work, because the software is sophisticated. Ask the broker to explain the principle to you. If their answers are vague and evasive, it is probably not a good idea to use such programs.

4. Multi-level marketing. These pyramid schemes just use the forex trading market as a platform for recruiting new members and scamming money out of them. The red flags of MLM schemes are focus on recruitment, not on trading itself, promises of downline growth and unrealistic profits, and lack of transparency.

5. Forex pyramids. They are somewhat similar to MLM companies, also focusing on recruitment to an investment community. However, in this case, the leaders make money from the membership fees they charge. Do not confuse a forex pyramid with a social trading community — the latter will always use a reliable and regulated broker.

6. Impostors and clone firms. They impersonate reputable forex brokers or financial institutions. The red flags are cold calls, fake websites, asking for payment in advance. Usually they target the beginners or careless traders.

7. Binary options. Technically they are not a scam, but they are very high-risk. Traders predict the price movement of an asset within a set time period, and either get a payout if the prediction is correct, or lose the investment if it is not. It is similar to gambling, so binary options are banned in some countries. The data shows that more that 85% of binary options traders lose their money.

Practical tips on avoiding forex scams

Protect your capital while trading with the following tips.

1. Choose a reliable broker regulated by a financial authority. Regulated brokers must follow strict standards that protect traders and guarantee fair trading practices. In major countries, there are regulatory bodies: do the research on their website and check if your broker is regulated.

2. Do not trust promises or guarantees of great profit in a short time with little risk and low effort. Forex trading implies risk, and no one can guarantee profit unless they are trying to mislead you.

3. A high-leverage offer from an unregulated broker can seem appealing, but beware: as we mentioned earlier, a high risk of losses always follows high leverage.

How to choose a reliable broker

To secure your investments and avoid fraud, choose your broker wisely. Look for these characteristics.

1. Reputation and regulation: a reputable broker is registered with a regulatory body in your country. Do not hesitate to check. You can find the information about this on their website.

2. A diversity of account types, varying by such features as spread, leverage, margin, commission, and deposit conditions.

3. A variety of currency pairs available for trading.

4. User-friendly trading platform, easy to navigate and use not only for trading itself but also for analysis.

5. Reliable customer support, which makes the trading experience more comfortable, especially for new investors.

I’ve been scammed. What should I do?

Fell victim to a fraud? Follow these steps.

1. First of all, you should act fast to try and recover your investments. Immediately cease all the transactions with the suspicious broker. Do not deposit any more money into your account.

2. Collect all the evidence relevant to the unethical broker: transaction details, emails, chat logs, and trading history. Record all the suspicious activity and misleading information.

3. Report the scam to the authorities. It can be the regulatory body in your country and the police.

4. Contact your bank for help.

5. Check if the broker you worked with is regulated. Even if they are not, report them anyway to help the regulator track them down and prevent future crimes.

6. Warn other traders. Spread information about the scam: post on social media and forex forums. It may help other people to avoid becoming victims of the same fraudulent scheme.

7. Unfortunately, there are recovery scams that target misguided investors. Frauds promise help to recover lost funds for a fee, but do not fall for it: start legal action.

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FAQ

Is forex trading legal?

Contrary to many misconceptions, trading forex is completely legal. However, you should beware of potential scammers and frauds. Watch out for red flags and be careful when choosing a broker. If you are just starting out, learn more about the specifics of the market, try a demo account first, and know how to distinguish honest brokers from scammers.

Do I have enough money to start trading forex?

Any amount of money will do. As little as $5 in your account can bring you profit.

What really matters is the experience, analytical skills and courage to take calculated risks. Keep in mind that even seasoned traders can make mistakes due to the forex market’s volatility and the factors affecting price movements.

You can use leverage if you do not have enough capital. However, it can be risky and lead to unexpected losses. Carefully consider all the benefits and drawbacks before using this instrument.

Are forex markets volatile?

Foreign exchange markets can often be very volatile. The prices of currencies can change quickly and sometimes unpredictably. Several factors influence the exchange rates: global economics, major political events, and market sentiment. This volatility is a risk factor, but many traders see it as an opportunity for profit. However, relevant experience in forex is necessary to assess risks and protect your money.

Are forex markets regulated?

Forex markets are regulated, but the level of regulation varies by country. There are financial regulatory bodies in some countries and regions that oversee forex trading. They make sure that the market is transparent, prevent fraud, and protect traders. The CFTC and the NFA operate in the US. In the EU, many countries comply with the common standards set by the European Securities and Markets Authority, but each country has its own regulatory body.

Though regulators help to keep fair practices on the market, forex markets are decentralized. Investors from all over the world trade FX. That means not all brokers are regulated, so choose licensed brokers to avoid scams and fraud.

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