What is forex?

Chapter 1: What is forex?

Of all the financial markets, forex is the biggest. Roughly $4 trillion is traded globally every working day. And in many ways it’s the easiest to get your head around.

‘Forex’ or ‘FX’ stands for ‘foreign exchange’. You sell the currency you are holding, let’s say Pounds Sterling, and buy another one, let’s say US Dollars.

And, just like when you buy your currency when you go abroad on holiday, the bank, post office or foreign exchange booth at the airport will quote two prices: one to sell you the US Dollars, and another to buy them from you and pay you Sterling.

The bulk of forex trading involves just three currencies – US Dollars, Euro and Japanese Yen. (For example, selling US Dollars to buy Euros, selling Euros to buy Yen and so on.) But of course forex trading can take place between any two of the many currencies used around the world.

Chapter 2: Why trade forex?

That depends. For some, it’s about getting hold of real money – as people may need to obtain a currency to buy goods or services. This could include manufactured goods or securities, such as stocks or bonds denominated in a foreign currency.

There’s also the investment opportunity. You could choose to buy a foreign currency because you may earn more interest on your money than in the currency you are holding.

And then there’s speculation. This is about selling your “base currency” and buying another in the hope that – when you sell it again – you’ll end up with more of the currency than you started with.

Chapter 3: Who trades forex?

The biggest buyers and sellers of forex are banks. Even though they may trade for their own book, they are mostly carrying out deals for customers (who may be looking to access money, invest or speculate). 

Although hundreds of banks and brokers trade forex, the market is dominated by the ‘big five’: Citigroup, Deutsche Bank, Barclays, JP Morgan and UBS. Together they accounted for over half the global market turnover in 2015.

Chapter 4: Jargon busting

Forex is an over-the-counter (OTC) market. This means that trading doesn’t happen on a stock exchange, but instead between counterparties directly or via a matching platform.

On trading screens and websites, you’ll see currencies are shown by short codes: for example, US Dollars is USD, Euro is EUR, Japanese Yen is JPY. ISO, the international standards organisation, lists 268 different currencies.

The majority of forex trading is known as ‘spot’. This means prices are quoted, deals are done and the proceeds paid to the appropriate bank account more or less immediately. 

However there are also forward foreign exchange contracts. This means the bank or broker will agree a rate with you today, for the currency that you wish to buy or sell at an agreed future date.

Chapter 5: How to trade in forex?

A bank or a broker will typically give you access to their online dealing platform. You can then link it to your bank account and start trading. There are also many specialist forex trading platforms that are designed for private individuals to trade.

Chapter 6: The good and the bad

One big advantage in trading forex (say, compared to shares) is that you will always have an asset. So if you sell USD and buy EUR, at the very least you will hold EUR. 

What’s more, while you’re holding the currency you bought, you could earn interest on it from the bank that’s holding it for you. And if your position pays off you may also make a profit when you sell those euros back to dollars.

The bad news is that exchange rates could go against you, and you lose money when you trade back into your base currency. You may also make no interest on the currency you own if interest rates are rock bottom.