What is Forex and How Does It Work?

Photo: Internet

What is forex trading?

Forex, or foreign exchange, can be explained as a network of buyers and sellers, who transfer currency between each other at an agreed price. It is how individuals, companies, and central banks convert one currency into another – if you have ever traveled abroad, it is likely you have made a forex transaction.

While a lot of foreign exchange is done for practical purposes, the vast majority of currency conversion is undertaken to earn a profit. The amount of currency converted every day can make price movements of some currencies extremely volatile. This volatility can make forex so attractive to traders: bringing about a greater chance of high profits while also increasing the risk.

The foreign exchange market is the world's largest financial market in terms of trading volume, with a daily trading volume of US$5 trillion. Therefore, transactions in the foreign exchange market are very active and highly liquid. Due to its strong liquidity, currency exchange rates often react very quickly to market news, political situations, and key economic events. The volatility of the foreign exchange market largely reflects the region's political and economic events where the currency is located.

How does foreign exchange trading work?

A forex position is always quoted in currency pairs, GBP/USD (also known as cable). To profit, you need to look at the fluctuations in the two currencies' exchange rates. The first currency is called the base currency. Forex traders speculate on whether it will improve or decline against the quote currency.

When you open a trading position, you speculate on the direction in which the market moves. You either begin a buying (long) or selling (short) position, depending on what direction you think the value of the currency will go. Price movements in the forex market are affected by the strengthening and weakening of the currencies' value.

For example, GBP is the base currency, and USD is the quote currency. If GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.

If the pound rises against the dollar, then a single pound will be worth more dollars, and the pair's price will increase. If it drops, the pair's price will decrease. So if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (going long). If you believe it will weaken, you can sell the pair (going short).

Forex trading does not take place on exchanges but directly between two parties, in an over-the-counter (OTC) market. The forex market is run by a global network of banks, spread across four major forex trading centers in different time zones: London, New York, Sydney, and Tokyo. Because there is no central location, you can trade forex 24 hours a day.

Photo: Internet

There are three different types of forex market:

Spot forex market: the physical exchange of a currency pair, which occurs at the exact point the trade is settled – i.e., 'on the spot' – or within a short period.

Forward forex market: a contract is agreed to buy or sell a set amount of a currency at a specified price, to be settled at a set date in the future or within a range of future dates.

Future forex market: a contract is agreed to buy or sell a set amount of a given currency at a fixed price and date in the future. Unlike forwards, a futures contract is legally binding.

Most traders speculating on forex prices will not plan to take delivery of the currency itself; instead, they make exchange rate predictions to take advantage of price movements in the market.

Like most other financial markets, supply and demand primarily control the price movements in the forex markets. Banks and other big investors want to pour in capital into economies with strong potentials.

If good news about a particular country reaches the markets, investors would be encouraged to put more money, increasing the demand for the country's currency.

If there is no corresponding increase in the currency's supply, the higher demand will trigger the price to rise. Likewise, bad news can discourage investors from putting money. This will, in turn, cause the price of the currency to drop. It can be said that a country's currency reflects the economic condition of the country it represents.