What Is Forex?
Also known as forex (or FX), foreign exchange is an over-the-counter market where individuals, banks, and businesses convert one currency into another. It is considered the largest liquid market in the world.
How Does the Foreign Exchange Market Work?
Unlike stocks and commodities, there is no central market for trading forex. Instead, a forex market trades via a global network of banks, dealers, and brokers. This means forex trading can take place 24 hours a day, 5 days a week.
How Are Forex Prices Determined?
Forex prices are quoted in pairs. This is because you're selling one currency while buying another.
Foreign exchange prices are influenced by a variety of factors including:
- Interest rates
- Government policy
- Import and export demand
Because of these factors and the high volume of traders, prices change rapidly. This makes for an extremely volatile market – and that means higher risk for investors.
Example of Forex Pricing
Let’s look at an example of forex pricing using the US Dollar and the euro. Currencies are expressed as 3 letter abbreviations. On the left is the base currency, in this case, the US Dollar or USD. This is being exchanged (i.e. traded) for the EUR on the right, which is referred to as the quote:
Say that $1.00 US is worth $0.84 euro. Keep in mind, however, that these prices change all the time.
How to Trade Forex
In forex trading, you’re using one currency to buy another. You expect that the currency you bought will increase in value compared to the one you sold. If it does, you’ll close your trade and sell at a profit. If you’re wrong, you’ll have to sell at a lower price than you paid and experience a loss.
The principle of buying low to sell high is a familiar one. However, both forex trading’s math and currency conventions can be challenging for beginners.
Knowing Forex Terminology
When you trade forex, you’re quoted two prices:
- The bid represents the amount you will get if you sell the currency
- The ask represents how much you will need to spend to purchase the currency
The difference between the two is called the spread, and that represents the cost of forex trading. The bigger the difference, the more it costs to buy and sell that specific currency. Remember: The goal is to buy low and sell high with the trade.
The second major concept to understand is currency conventions. Different quoting conventions depend on the currency and the market. For example, euro exchange rates are often quoted in US dollars. A quote for EUR of 1.1151 would mean that you could buy one euro for about 1.1151 US dollars.
Here’s where it can get tricky: Other currencies – like the Japanese yen (JPY) – have quotes that specify the number of yen that can be purchased with a single US dollar. For example, a quote for JPY of 107.58 means that 1 US dollar can be purchased for 107.58 yen.
If you decided to buy euro and the quote increased, you would make money because your one euro would now purchase more US dollars. If you bought the yen and the quote increased, you’d lose money because it would now take more yen to buy one US dollar.
For some investors, this can cause confusion and cause them to place unintended trades. Before jumping into these high-risk investments, you should have a firm grasp of both currency conventions and forex trading terminologies.
For more about forex trading currencies and risk, head over to the SEC individual investor page.
Example of Foreign Exchange
Let's say you purchase 100,000 euros (a standard lot) at the EUR/USD exchange rate of 1.5000. This means it costs 1.5 U.S. dollars to purchase 1 euro.
Within a week, the rates change and it takes $1.5200 to purchase 1 euro. You choose to sell. In this trade, you spent $150,000 to buy the euros and later received $152,000. This provides you with a profit of $2,000.
Common Forex Trading Strategies
Traditionally, investors use fundamental analysis to decide whether an investment will provide a high return. Fundamental analysis looks at the long-term data and relies on time to make money.
Forex is an open and especially volatile market. In these types of high-risk, fast-moving markets, technical analysis tends to work better than fundamentals. In other words: You need to make quick decisions because you’re not going to buy and hold for the long term.
Technical Indicators for Forex Trading
There are two common standard technical indicators:
Both are great tools for forex trading since they can be used over any time frame and customized to suit individual styles. More advanced ideas (like the Elliott Wave theory and Fibonacci retracement levels) can also work in forex. However, these are difficult concepts to understand and are best left to advanced traders.
Traders will look at static levels of a technical indicator to try and determine what a market will do. They will look to see if it is due to move lower (after it becomes overbought) or if it is ready to move higher (after reaching an oversold extreme).
The problem with common trading strategies like this is that everyone knows about them. Some traders may think they are smarter than the strategy and will try to get in ‘ahead’ of the signal that an indicator provides. This means they’ll take a huge risk by purchasing currency without following the indicator. Others are more cautious and wait until the indicator moves to a more favorable position before buying.
Is Forex Trading Right for Me?
There is no single strategy that will always work, and that’s especially true when it comes to trading forex.
Forex trading isn’t for everyone, but it’s certainly an option for well-educated investors who are looking for a diversified portfolio of investments. However, since forex trading is extremely high risk, you’ll only want this to make up a small portion of your portfolio