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Foreign Exchange (Forex)

Updated August 9, 2020

What Is Foreign Exchange (Forex or FX)?

Foreign Exchange, also known as  Forex or FX, is an over-the-counter market. Forex trading is how individuals, banks, and businesses convert one currency into another.  It is considered the largest liquid market in the world.

How Does the Forex 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.

Forex Trading: Pricing

Forex prices are quoted in pairs. This is because you are selling one currency while buying another. 

Foreign exchange prices are influenced by a variety of factors including: 

  • Interest rates
  • Inflation 
  • Government policy 
  • Import and export demand

Because of these factors and the high volume of traders, the prices change rapidly. This makes for an extremely volatile market, which means high risk for investors.

Forex Pricing Example

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 (traded) for the Euro or EUR on the right, called the quote. 

Recently,  $1.00 US is worth $0.92 euro.  Keep in mind these prices change all the time. 

What Are Forex Lots?

When trading forex, you must purchase or sell a specific amount of currency units. This is called a lot. 

The standard size for a lot is 100,000 units (1.0). There are also mini, micro and nano lots. The common values for these lots are: 
Mini - 1/10th of a lot or 10,000 units
Micro - 1/100ths of a lot or 1,000 units
Nano lots are not as common. They are very small lots created by brokers. Generally they are 100 units. However, there is not a standard for these small lots.

How to Trade Forex

In forex trading, you are using one currency to buy another. You are expecting that the currency you bought will increase in value compared to the one you sold. If it does, you will close your trade and sell at a profit. If you are wrong, you will 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, forex trading math and currency conventions can be challenging for beginners. 

Basics of Forex Trading

If you’re considering forex trading, you need to understand a few basics. 

The terminology 

When you trade forex, you’re quoted two prices: 

  1. The bid represents the amount you will get if you sell the currency
  2. The ask represents how much you will need to spend to purchase the currency 

The difference between the two is called the spread. The spread 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. 

Currency Conventions

The second major concept you need to understand is currency conventions. There are different quoting conventions that 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 means you can one euro for about 1.1151 US dollars. 

Here is 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. A quote for JPY of 107.58 means that 1 US dollar can be purchased for 107.59 yen.

If you bought the euro and the quote increases, you would make money, because your one euro would now buy more US dollars. If you bought the yen and the quote increases you would lose money, because it would now take more yen to buy one US dollar.

You can see how for some investors, this could cause confusion and cause them to place an unintended trade. 

You should have a firm grasp on both currency conventions and forex trading terminology before jumping into this high-risk investment. For more about forex trading currencies and risk, head over to the U.S. Securities and Exchange Commission individual investor page.

Forex Trading Example

Let’s look at a basic forex trading example before we go over forex trading strategies. 

Let's say you purchase 100,000 (a standard lot) euros at the EUR/USD exchange rate of 1.5000. This means it costs 1.5 U.S. dollars to purchase 1 euro. 

In one week rates change and now it takes $1.5200 to purchase 1 euro. You choose to sell.  In this trade, you spent $150,000 to buy the euros and you received $152,000. This gave you a profit of $2,000.

Common Forex Trading Strategies

Traditionally, investors use fundamental analysis to decide if 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 and fast-moving markets, technical analysis tends to work better than fundamentals. In other words, you’re not going to buy and hold for the long term so you need to make quick decisions. 

Technical Indicators for Forex Trading

There are two common standard technical indicators: 

  • RSI - Relative Strength Index
  • MACD- Moving Average Convergence Divergence 

These are both great tools for forex trading since they can be used over any time frame and can be customized to suit your individual style. More advanced ideas like 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 an indicator like RSI or MACD to figure out what a market is going to do. They will look to see if it is due to move lower (after it becomes overbought) or if it is ready to go 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 an indicator may give. This means they take a huge risk and buy currency without following the indicator. Others will be more cautious and wait until the indicator moves to a more favorable position before buying- taking less risk. 

Your takeaway should be that there is no single strategy that will always work. Especially when it comes to trading forex.

Forex Trading Is Risky and Not for Beginners

The forex market is crucial for supporting a country's imports and exports.  Since many currencies abound this is an important market that provides a clearinghouse to trade those major currencies.

That said, Forex trading isn’t for everyone. It is an option for a well-educated investor. As always, it’s important you have a diversified portfolio of investments. Since forex trading is a very high risk, you will want this to only be a small portion of this portfolio if you choose to explore it. 

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Rachel Siegel, CFA is one of the nation's leading experts at ensuring the accuracy of financial and economic text.  Her prestigious background includes over 10 years of experience in creating professional financial certification exams and another 20 years of college-level teaching.

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