What is Forex (FX) Trading and How Does it Work?

The foreign exchange (forex) market is a global decentralised market for the trading of currencies. It is the largest and most liquid market in the world with a daily dollar volume of $6 trillion. 

Trading is not centralised at a physical location or an exchange, as with the equities and futures markets. Instead, various financial institutions trade currencies between themselves via a global network known as the interbank market. This market runs 24 hours a day, 5 days a week (from 9 p.m. GMT on Sunday until 8 p.m.GMT on Friday). 

Trading forex involves simultaneously buying one currency and selling another. Currencies are traded in pairs, e.g. the pound sterling against the US dollar (GBP/USD). The first currency in the pair is called the base currency and the second is called the counter or quote currency. 

So if the GBP/USD is trading at 1.3118, this means that £1 is worth $1.3118. The exchange rate is the amount of the quote currency (USD) that is equal to 1 unit of the base currency (GBP).

If you are bullish and believe the base currency in a currency pair will appreciate against the quote currency, you can buy (go long) the pair. If you are bearish and think the base currency will weaken against the quote currency, you can sell (go short) the pair.

A standard lot size in forex trading is 100,000 units of the base currency. For this contract size, each pip (a standard price increment) is worth $10. Many firms now offer access to trading in mini lots of 10,000 and micro lots of 1,000.

Forex pairs are broken down into different categories as follows: 

• Major pairs.  EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD are considered to be the major currency pairs.
• Minor pairs. These are currency pairs that include any two of the major currencies excluding USD. For example, GBP/EUR and AUD/JPY.
• Exotic pairs. These are pairs that are made up of a major currency against one from an emerging economy. For example, EUR/TRY and USD/HUF.

Before starting to trade forex it is highly recommended to spend some time learning about the market and factors such as the risks of using leverage. 

To get started trading forex you will need to open an account with a brokerage firm. This is normally a relatively fast and easy process that can be done online via the broker’s website. Before any broker can accept UK forex and CFD traders as clients, the broker must become authorised by the Financial Conduct Authority (FCA), which is the financial regulatory body in the UK.

Many brokers require very low minimum deposits to get started. In fact, there is often a £0 minimum to open an account. Due to regulatory requirements, some brokers now have a ‘Know your Customer’ (KYC) questionnaire as part of the application. This aims to ensure that brokers understand your risk tolerance, market knowledge, and overall financial situation. It may include some basic questions about trading forex and CFDs.

Most brokers offer a free demo account where you can practice trading without risking any real money. Before trading in a live account it is advisable to develop a strategy and test it in a demo account. In addition, micro accounts and flexible lot sizes allow new traders to practice with real money while keeping risk to a minimum.

Forex trading can be profitable, but the statistics shared by major brokerage firms show that the majority of traders lose money. 

Data compiled on January 18th, 2022

Major factors leading to trader losses include inappropriate use of leverage, lack of education, and costs of trading such as spreads or commissions. It should also be emphasised that timing the market and trying to predict short-term moves in the market are extremely difficult.

Margin is the initial capital required to open and hold a leveraged position in the market. For example, a margin requirement of 1% equates to available leverage of 1:100. This means that with £1,000 a trader can control a market position of £100,000. Margin is a percentage of the full value of a trading position that a trader must have available in their account in order to place and hold the trade. 

Brokers have different margin requirements and available leverage depending on their location and the requirements of local regulators. For example, traders with United Kingdom-based brokers have access to 1:30 leverage, reflecting a margin requirement of 3.3%. This is because 1:30 is the maximum leverage allowed for standard accounts by the UK Financial Conduct Authority (FCA). Meanwhile, the requirements of offshore regulators are far less stringent.

Traders with accounts at brokers based offshore often have access to leverage as high as 1:500, with a margin requirement of just 0.2%. 

Making use of low margin requirements and trading with high leverage allows traders to dramatically increase their exposure to movements in the market. Leveraged trading comes with a high level of risk. Often described as a ‘double-edged sword’, leverage can magnify both profits and losses.

The spread is the gap between the bid and offer prices of a currency pair. For example, imagine that in GBP/USD the bid price is 1.3112 and the offer price is 1.3116. This means that the best price that you can currently buy GBP/USD is 1.3116 and the best price you can currently sell at is 1.3112. In this case, the spread, the difference between the bid and offer prices, is four pips. Pip is an acronym for “percentage in point” or “price interest point” and is a unit of measurement (one-hundredth of one percent) expressing the change in value of an exchange rate.

Forex trading has important advantages and disadvantages compared with other markets. Recent developments in the equities market, such as the advent of fractional share trading and commission-free trading, have eroded some of the advantages of forex.

• Ease of access. Forex trading accounts can often be opened online within a half-hour and funded with as little as £100. As a true 24/5 market, traders can easily get in and out of positions at any time of the day or night. 

• Fees. Since the forex market is decentralised, there are no exchange or clearing fees. Normally, the costs of entering a trade are priced into the spread, unless you are trading with an ECN (Electronic Communications Network) broker when there is an additional commission. ECN brokers provide direct access to other participants in the market, rather than taking the other side of client trades.

• Leverage. The forex market offers an unusually high level of leverage, which is typically seen as an advantage. As mentioned above, increased leverage can amplify both gains and losses, so it does not always work in the trader’s favour. 

• Flexibility of lot size. Traders are usually not restricted to trading full-sized lots of 100,000 units of the base currency. Many brokers offer trading in mini lots of 10,000 units or micro lots of 1000 units. 

• Ease of short selling. The ability to short sell a currency pair is a given, while in other markets such as stocks, this is not the case.  

• Liquidity. The massive size of the forex market and tremendous volume of trading means that it is a highly liquid market. This makes it more likely that you will receive the price intended when executing a trade. An additional benefit is that highly liquid markets are harder to manipulate, which creates a better trading environment for all participants.

• Lack of Regulation. Regulatory oversight is often limited in the forex market. For example, a trader opening an account with a broker regulated by the Cyprus Securities and Exchange Commission (CySEC) has the benefit of segregated funds, negative balance protection, and a compensation fund in the event that the broker becomes insolvent. A trader opening an account with a broker based offshore will not be guaranteed such protections. Making it more confusing is the fact that large brokers typically have multiple entities across the globe overseen by different regulators. If they have an entity regulated by CySEC, this will only protect the clients within the EU. If they also have an offshore entity, the clients with the offshore entity will not benefit from the same protections. 

• Conflict of Interest. Market Maker/Dealing Desk forex brokers automatically take the other side of a client’s trade. This means that when a client loses money they will make money, creating an inherent conflict of interest. 

• Dividends. Stocks sometimes make dividend payments which is something not present when investing in currencies. However, forex traders can potentially capitalise on different interest rates between currencies using a strategy known as the Carry Trade. This strategy is based on buying a pair where the base currency has a high interest yield and the quote currency has a low yield. In doing this the investor can earn the interest rate differential: the interest earned from buying the high yielding pair minus the interest paid from selling the low yielding pair. Leverage can be used to magnify earnings from the Carry Trade. For example, a 4% interest rate differential will become 400% at 1:100 leverage.

Forex trading is a legal and legitimate form of trading. Unfortunately, due to the decentralised and often under-regulated nature of the market, it has become notorious for scams. Individuals must be careful to do their due diligence when selecting a broker and also be careful not to be lured into buying courses or software that promise quick profits.

Forex is an interesting market for short-term traders, swing traders, and long-term investors. The market lends itself well to both technical and fundamental trading strategies. Being highly liquid and an uninterrupted 24/5 market also makes forex a good market for automated and algorithmic trading.

• Can I trade forex with £100? Yes, there are many brokers that offer trading with initial deposits of £100 or less.
• Should I trade forex or stocks? The forex market has some advantages over trading stocks. These include the high available leverage, volatility, and liquidity of the forex market. 
• Which forex pairs correlate? Examples of currency pairs with positive correlations include AUD/USD vs. NZD/USD and EUR/USD vs. GBP/USD. 
• Is forex a pyramid scheme? No, the forex market is not a pyramid scheme.
• Which forex pairs move the most? The most volatile instruments are typically minor or exotic currency pairs. AUD/JPY, USD/SEK, and USD/TRY are examples of highly volatile currency pairs. 

How do forex brokers make money? Forex brokers make money via the bid/offer spread, commissions, overnight swap fees, and miscellaneous fees such as inactivity fees or withdrawal fees.