What is forex trading?
Forex trading is the means through which one
currency is changed into another. When trading forex, you are always trading
a currency pair – selling one currency while simultaneously
buying another.
Each currency in the pair is listed as a
three-letter code, which tends to be formed of two letters that stand for the
region, and one standing for the currency itself. For example, USD stands for
the US dollar and JPY for the Japanese yen. In the USD/JPY pair, you are buying
the US dollar by selling the Japanese yen.
Some of the most frequently traded FX pairs
are the euro versus the US dollar (EUR/USD), the British pound against the euro
(GBP/EUR), and the British pound versus the US dollar (GBP/USD).
To keep things ordered, most providers split
pairs into the following categories:
Four types of forex pairs:
·
Major pairs - seven currencies that
makeup 80% of global forex trading. Includes EUR/USD, USD/JPY, GBP/USD and
USD/CHF
·
Minor
pairs - less frequently
traded, these often feature major currencies against each other instead of the
US dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
·
Exotics
pairs- a major currency against
one from a small or emerging economy. Includes: USD/PLN, GBP/MXN, EUR/CZK
·
Regional
pairs - pairs classified
by region – such as Scandinavia or Australasia. Includes: EUR/NOK, AUD/NZD,
AUD/SGD
Most forex transactions are carried out by
banks or individuals by seeking to buy a currency that will increase in value
against the currency they sell. However, if you have ever converted one
currency into another, for example, when traveling, you have made a forex
transaction.
How does forex trading work?
Institutional forex trading takes place
directly between two parties in an over-the-counter (OTC) market. Meaning there are no centralized exchanges (like the stock
market), and the institutional forex market is instead run by a global network
of banks and other organizations.
Transactions are spread across four major
forex trading centers in different time zones: London, New York, Sydney, and
Tokyo. Since there is no centralized location, you can trade forex 24 hours a
day.
Most traders speculating on forex prices do
not take delivery of the currency itself. Instead, traders will make exchange
rate predictions to take advantage of price movements in the market. The most
popular way of doing this is by trading derivatives, such as a rolling spot
forex contract offered by IG.
Trading derivatives allows you to speculate on
an asset’s price movements without taking ownership of that asset. For
instance, when trading forex with IG, you can predict on the direction in which
you think a currency pair’s price will move. The extent to which your
prediction is correct determines your profit or loss.
The three different types of forex market:
There are three different ways to trade on the
forex market: spot, forward, and future.
·
Spot
forex market: the physical exchange
of a currency pair, which takes place at the exact point the trade is settled –
ie ‘on the spot’ – or within a short period of time. Derivatives based on the
spot forex market are offered over-the-counter by dealers like IG.
·
Forward
forex market: a contract is agreeing
to buy or sell a set amount of a currency at a specified price, and to be
settled at a set date in the future or within a range of future dates
·
Futures
forex market: an exchange-traded
contract to buy or sell a set amount of a given currency at a set price and
date in the future.
Forex pricing – base and quote currency
The first currency listed in a forex pair is
called the base currency, and the second currency is called the quote currency.
The price of a forex pair is how much one unit of the base currency is worth in
the quote currency.
In the above 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 think it will weaken, you can sell
the pair (going short).
What is leverage in forex trading?
A key advantage of spot forex is the ability
to open a position on
leverage. Leverage allows you
to increase your exposure to a financial market without having to commit as
much capital.
When trading with leverage, you don’t need to
pay the full value of your trade upfront. Instead, you put down a small
deposit, known as margin. When you close a leveraged position, your profit or
loss is based on the full size of the trade.
This means that leverage can magnify your
profits, but it also brings the risk of amplified losses – including losses
that can exceed your initial deposit. Leveraged trading, therefore, makes it
extremely important to learn how to manage your risk.
What is margin in forex trading?
Margin is a key part of leveraged trading. It is the term used to describe the initial
deposit you put up to open and maintain a leveraged position. When you are
trading forex with margin, remember that your margin requirement will change
depending on your broker, and how large your trade size is.
Margin is usually expressed as a percentage of
the full position. So, a trade on EUR/USD,
for instance, might only require a deposit of 2% of the total value of the
position for it to be opened. Meaning that while you are still risking $10,000,
you’d only need to deposit $200 to get the full exposure.
What is a pip in forex trading?
Pips are the units used to measure movement in
a forex pair. A forex pip usually refers to a movement in the fourth decimal
place of a currency pair. So, if EUR/USD moves from $1.35361 to $1.35371,
then it has moved a single pip. The decimal places that are shown after the pip
are called micro pips, or sometimes pipettes, and represent a fraction of a
pip.
The exception to this rule is when the quote
currency is listed in much smaller denominations, with the most notable example
being the Japanese yen. Here, a movement in the second decimal place
constitutes a single pip. So, if EUR/JPY moves from ¥172.119 to ¥172.129,
it has moved a single pip.
What is the spread in forex trading?
In forex trading, the spread is the difference
between the buy and sell prices quoted for a forex pair. If, for instance, the
buy price on EUR/USD was 1.7645 and the sell price was 1.7649, the spread would
be four pips.
If you want to open a long position, you trade
at the buy price, which is slightly above the market price. If you want to open
a short position, you trade at the sell price – slightly below the market
price.
IG offers competitive spreads of 0.8 pips for
EUR/USD and USD/JPY, and 1 pip on GBP/USD, AUD/USD and EUR/GBP.
What is a lot in forex trading?
Currencies are traded in lots – batches of
currency used to standardise forex trades. In forex trading, a standard lot is
100,000 units of currency. Alternatively, you can sometimes trade mini
lots and micro lots, worth 10,000 and 1000 units
respectively.
Individual traders don’t necessarily have
100,000 dollars, pounds or euros to place on every trade, so many forex trading
providers offer leveraged
What moves the forex market?
Like most financial markets, forex is
primarily driven by the forces of supply and demand, and it is important to
gain an understanding of the influences that drive these factors.
Central banks
Supply is controlled by central banks, who can
announce measures that will have a significant effect on their currency’s
price. Quantitative easing, for instance, involves injecting more money into an
economy, and can cause its currency’s price to drop.
Central banks also control the base interest
rate for an economy.
If you purchase an asset in a currency that
has a high interest rate, you may get higher returns. This can make investors
flock to a country that has recently raised interest rates, in turn boosting
its economy and driving up its currency.
However, higher interest rates can also make
borrowing money harder. If money is more expensive to borrow, investing is
harder, and currencies may weaken.