What is Forex? Understanding the market for exchanging foreign currencies

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• Forex is a global marketplace for trading one currency for another.
• Central banks are also involved in the forex market, buying and selling currencies in order to push the value of their native currency either higher or lower.
• The forex markets offer investors liquidity and 24/7 trading - but they're highly volatile.

If you've already begun your investing journey, the stock market is a familiar place. But if you're looking to expand your portfolio and see how else you can strengthen your portfolio, there's foreign exchange, or forex.

Forex involves trading one currency for another. For example, a person could exchange the US dollar for the Japanese Yen. Forex offers deep liquidity and 24/7 trading, so investors have ample opportunities to get involved.

Understanding forex

The forex market is a global electronic network of banks, brokers, hedge funds, and other traders. This market is where one currency is traded against the other in an effort to turn a profit.

Central banks are also involved in the forex market, where they're responsible for maintaining the value of their countries' currency. This value is represented as the exchange rate by which it will trade on the open market.

Market participants can trade in the spot market and also buy and sell derivatives. As a result, they can trade futures, forwards, and swaps.

Quick tip: The spot market is a financial market where investors can trade currencies, commodities, and securities instantly.

Investors trade forex in pairs, which list the base currency first and the quote currency second. For example, if someone trades the JPY/USD, the Japanese Yen is the base currency, and the US dollar is the quote currency.

Investors who are interested in forex have the ability to trade several different currency pairs: major pairs, minor pairs, exotic pairs, and regional pairs.

• The major pairs involve the US dollar, and include USD/JPY, EUR/USD, USD/CHF, and EUR/USD. These four currency pairs account for 80% - a strong majority - of forex trading, according to figures provided by IG.
• The minor pairs, which consist of other major currencies, include GBP/JPY, EUR/GBP, and EUR/CHF.
• There are exotic pairs, which involve a major currency combined with a minor currency, such as EUR/CZK, USD/PLN, and GBP/MXN.
• Then there are regional pairs, which are named for different geographic regions, for example Australasia or Scandinavia. AUD/SGD, EUR/NOK, and AUD/NZD all count as regional pairs.

The world's most-traded currency, by far, is the US dollar; it experiences more than $5 trillion worth of trading volume per day, according to figures from the Bank for International Settlement (BIS). The data from BIS also reveals the Euro as a not-so-close second, with more than $2.1 trillion in daily trading volume, and the Japanese Yen and pound sterling are the third- and fourth-largest currencies by average daily trading volume, at $1.1 trillion and $844 billion, respectively.

The forex market

This global market has two tiers: the interbank market and the over-the-counter (OTC) market. The interbank market involves institutions that exchange currencies with each other and have the ability to set exchange rates because of the magnitude of their trades.

The OTC market is different in that it involves transactions that are made electronically instead of going through a third party like a broker or exchange.

The origins of forex

Different narratives have been provided as to when the forex markets first originated. Some have asserted that forex existed thousands of years ago. The barter system, in which people would trade goods for other goods, first came into existence during the time of Mesopotamia tribes.

As this system progressed, merchants would travel between different regions on ships in order to trade goods like spices and salt for other items, creating the first foreign exchange.

How forex trading works

Forex trading involves trading currency pairs in an effort to hedge or speculate. For retail investors, the process of forex trading involves opening a brokerage account, funding it, and then trading.

Once set up, if an investor thinks that the US dollar will rise compared to the Japanese Yen, they could buy the US dollar and sell the Yen. However, if that same investor thinks the Euro will decline relative to the US dollar, they can sell the EUR/USD by opening a sell position for one lot of that pair.

Either way, if their bet is accurate, they will make a profit. However, if their prediction isn't accurate, they will suffer a loss.

Investors trade currencies in lots, which are simply the number of units of those currencies. There are standard, mini, micro, and nano lots, which consist of 100,000, 10,000, 1,000, and 100 currency units, respectively.

Traders frequently aim to capitalize on small fluctuations in exchange rates, which are measured in pips, which represent one one-hundredth of 1 percentage point.

Note: Some forex traders use the term "greenback," which is a slang term that refers to the US dollar.

Hedge funds also use brokers. "[They] generally use institutional brokers, but they often also use the same brokers as retail investors - although they will almost always negotiate volume discounts/better terms," says Tim Enneking, managing director of hedge fund manager Digital Capital Management.

Quick tip: Banks trade significant amounts of currencies through the interbank market. These financial institutions make transactions that are frequently worth between $10 million and $100 million. Banks have currency desks, which communicate with each other constantly, and this helps them to ensure that exchange rates are consistent.

The pros and cons of forex trading

Forex offers many pros, including deep liquidity, 24-hour-a-day access, and access to leverage, which can help provide stronger returns. Further, some forex brokers advertise themselves as offering no-commission trading.

Another major draw of trading forex is the small amount of capital a person needs to get started. "You can easily trade using leverage which means that you need relatively little capital to be able to trade forex," says Julius de Kempenaer, senior technical analyst at StockCharts.com.

"It is no problem to day trade or scalp as the forex market is a lot less regulated than the stock/bond market." Scalping refers to making trades that profit from small changes in the value of forex pairs.

But there are drawbacks as well - such as leverage, which can be a double-edged sword in that it can amplify both gains and losses. Further, Enneking notes that the forex market has low volatility. "Without leverage, it's a difficult market to make real money in," Enneking says.

Retail traders can face substantial risks because of easy access to leverage and lack of understanding of how it all works.

Forex example

One currency pair a person might want to trade is the EUR/USD. If this particular pair is trading for 1.15 pips, and they think the exchange rate will increase in value, they could purchase 100,000 Euros worth of this currency pair. If it goes up to, for example, 1.20, they would experience a gain. You could use the following equation to calculate your profit:

€100,000 x (1.2000-1.1500) = $5,000

After that, they could take determine their profit in euros using this formula:

$5,000/1.20 = €4,166.67

The financial takeaway

The forex market provides ample opportunities for traders, allowing them significant access to leverage, the ability to trade 24/7, and the possibility of getting started with a small capital outlay. There are plenty of online brokers they can use, providing them with a wealth of options.

However, they should keep in mind that while there is the potential for gains, there are also significant risks involved. For starters, leverage can amplify losses, and many retail traders who want to take part will find themselves competing with professional traders working for financial institutions.

"Neophytes have their work cut out for them," says Enneking. "There are a plethora of long-time, highly skilled, very knowledgeable players in the space. You have a long learning curve to climb to feel comfortable and become successful in the sector."

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