If you’ve taken a holiday abroad in recent years, then you’ve probably already participated in the forex market. You might have needed to exchange your pounds for euros if travelling to Europe, or for dollars if making a trip to the US.
Forex, taken from the term foreign exchange, is also known as FX or the currency market, and is the largest financial market in the world. As well as being traded by individuals and businesses, forex is important for financial institutions, central banks, and governments.
It facilitates international trade and investment by enabling people and companies that earn money in one currency to pay for things in another.
Why do people trade forex?
There are two main reasons individuals or institutions participate in the forex market:
Perhaps unsurprisingly, most forex transactions take place to make money. The person or institution making the trade has no intention of actually taking delivery of the currency, they’re just looking to turn a profit as the markets rise or fall.
Due to the sheer volume of currency traders and the amount of money exchanged, currency rates are one of the most volatile financial markets available.
2. Purchasing goods or services in another currency
When a transaction is made between two entities in different regions, a foreign exchange trade needs to take place to pay for the goods or services exchanged.
How a forex trade works
Forex is an over-the-counter (OTC) market. This means that, rather than being traded through an exchange – like shares – currencies are exchanged directly between two parties. As the forex market is run electronically via a global network of banks, trades can take place anywhere and at any time.
Forex prices are always quoted in currency pairs. This is because a forex trader is effectively buying one currency while selling the other. They would need some form of currency, such as US dollars, to purchase sterling for example, and vice versa.
Each currency in the pair is known by a three letter currency code. An example of a pair might therefore be GBP/USD (sterling against the US dollar) or USD/JPY (the US dollar against the Japanese yen).
The first currency listed in a pair is known as the base or primary currency. The second currency is known as the quote or counter currency.
A forex price indicates how much one unit of the base currency will buy of the counter currency. So, if GBP/USD is listed as 1.52433, this means one pound is worth 1.52433 dollars. Therefore to buy one pound, a trader would have to sell 1.52433 dollars. A trader selling one pound would receive 1.52433 dollars in return.
If a trader thinks the base currency will strengthen against the quote currency, they would buy the pair (go long). If they think the base currency will get weaker against the quote, they would sell the pair (go short)
Share price movements are measured in units of currency, but changes to the price of a forex pair are measured in units known as pips. For most major currency pairs, a pip represents a one-digit move in the fourth decimal place. If GBP/USD moves from 1.52433 to 1.52443, that 0.0001 USD rise represents one pip.
One exception to this rule is where the Japanese yen is the counter currency. This is because one yen is worth much less than one unit of the other major currencies (such as the dollar, pound, euro, Swiss franc, etc). So in this case, typically a movement in the second decimal place represents one pip.
Difference when spread betting
It’s important to note that many spread betting providers quote forex prices differently from the above to make it easier for their clients to see what represents a pip. For example IG would quote the GBP/USD price above as 15243.3 and the GBP/JPY price as 18342.8. A pip represents a 1.0 change in the price in both instances.
Theoretically, any currency in the world can be exchanged for another, meaning the variety of forex pairs that can be potentially traded is vast.
In practice, however, the majority of forex trades take place on a few select currency pairs called the majors. What constitutes a major pair varies widely depending on who you speak to, but most include the following six pairs which account for over 80% of global forex trade:
|Currency pair||Currency names|
|USD/JPY||US dollar/Japanese yen|
|USD/CHF||US dollar/Swiss franc|
|USD/CAD||US dollar/Canadian dollar|
|AUD/USD||Australian dollar/US dollar|
All of these pairs include the US dollar, which is by far the single most traded currency in the world.
Other currency pairs which are traded less frequently are known as minors. You may also hear of exotic or emerging pairs, which include a major currency against one from a small or emerging economy.
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