What is Forex and how does it work?

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Updated on February 12, 2024 If you don’t know what Forex is, you are probably completely new to the world of trading stock exchanges and financial markets. This is because ... Read More

Updated on February 12, 2024

If you don’t know what Forex is, you are probably completely new to the world of trading stock exchanges and financial markets. This is because it is the most tradable financial market in the world, which can bring you the desired profit, or, on the contrary, completely deprive you of your invested money. It depends purely on your fitness, luck, but mainly on knowledge. Therefore, come to find out something about Forex first. We have prepared for you the main things you should know about it before you start trading.

What is Forex and what is its meaning?

The importance of Forex can be easily deduced. It is an abbreviation of the English Foreign Exchange, which means foreign exchange market in Czech. So you can buy and sell different currencies here. Just to give you an idea – every day there are trades with a total value of approximately 5 trillion USD on Forex. About 15 million actors visit it daily.

According to estimates, 85% of all trades are made by traders who buy and sell currency for profit. The remaining 15% of transactions are carried out by state governments and multinational corporations that sell their services or goods across borders, or demand them from abroad. So it is not just an asset to trade, it is also a platform that is used for practical purposes.

What is traded on Forex?

Trading itself always takes place in currency pairs, where you sell one currency and buy another. Basically like when you exchange korunas for kunas in Croatia. The difference is that, while you often lose money when exchanging foreign currency in an exchange, in Forex you exchange money in order to make money from the movement of currencies.

The first currency of the pair, the one you buy, is called the base currency. The other of the pair, the one you sell, is called the quoted currency. The price of the currency pair then indicates how much the base currency is worth in the quoted currency. So if we have the EUR/GBP currency pair, the euro will be the base currency we will buy. On the contrary, the British pound will be the quoted currency for which we will buy the given volume of euros. So if we have an exchange rate of 0.84, then 1 euro is worth 0.84 British pounds.

Currency pairs

The selection of pairs here is huge. For better orientation, they are therefore divided into several groups:

Main pairs

These are the most traded pairs on Forex. Specifically, it is the US dollar and one of seven other currencies. If you are new to Forex, we recommend starting with them. You will pay the lowest spreads for them, and in addition, their rates are sufficiently flexible.

EUR/USDeuro and US dollar
USD/JPYUS Dollar and Japanese Yen
GBP/USDthe British pound and the US dollar
USD/CHFthe US dollar and the Swiss franc
USD/CADUS dollar and Canadian dollar
AUD/USDthe Australian dollar and the US dollar
NZD/USDthe New Zealand dollar and the US dollar

Cross couples

These currency pairs are no longer of much interest to traders. They lack the mobility of the main currency pairs and are characterized by higher spreads. The main currency pairs always stand against each other here, but we no longer find the US dollar among them. The advent of cross pairs in Forex has made it easier for companies that previously had to first convert their currency to dollars, and then buy foreign currency with dollars. 

EUR/GBPeuro and British pound
EUR/CHFEuro and Swiss Franc
GBP/JPYBritish pound and Japanese yen
EUR/AUDEuro and Australian Dollar
GBP/CHFthe British pound and the Swiss franc
EUR/CADeuro and Canadian dollar
EUR/NZDEuro and New Zealand Dollar
EUR/JPYeuro and Japanese yen

Exotic couples

In this case, one of the main currencies and a currency that is not one of the main currencies are facing each other. That is, the one that comes from a small or developing economy. Among them is the Czech crown. Trading exotic pairs is not very attractive due to their reluctance to move and high spreads. Hence, the cost of trading exotic pairs is higher for traders than major or cross pairs. These include, for example:

EUR/CZKeuro and Czech crown
GBP/PXNthe British pound and the Mexican peso
USD/PLNthe US dollar and the Polish zloty
USD/CZKUS dollar and Czech crown

Regional pairs

The last of the named are regional pairs. As the name suggests, it is a currency originating from a single region. For example from Australia or Scandinavia. An example of such a pair could be:

EUR/NOKeuro and Norwegian krone
AUD/NZDAustralian dollar and New Zealand dollar
AUD/SGDAustralian dollar and Singapore dollar

Forex markets

As for Forex trading itself, you can choose between three different ways. It does not matter whether you are an individual trader, a company or an institution. In addition to the spot forex market and the forward foreign exchange market, these three methods also include currency futures, i.e. the future foreign exchange market. In general, traders without experience tend to move in the spot forex markets. The other two mentioned are more suitable for larger traders. If only because they require a larger amount of capital. And even if trades with real currency are closed on the spot market, traders will usually not want to take the money for real. On the contrary, they will want to speculate on the rise and fall of the exchange market.

Spot forex market

The fastest of all these methods is the spot market, when the given pair is exchanged immediately. This is done based on the current exchange rate. This can be influenced by many factors – starting with the current economic situation and ending with the political situation. The spot market is not only the largest but also the most important in Forex. If only because other forex markets are based on it. So if you ever hear someone talking about the foreign exchange market, they are probably referring to this type of transaction. But it is important to say one thing. Although the trade takes place “right now”, actual cash settlement can take up to two business days.

Forward forex market

While in the spot market you trade real currency, trading in forwards takes place through contracts. It is an agreement between two parties where the other party undertakes to pay you a certain amount of one currency for a given amount of another currency. However, this is not an instant trade. This contract gives you the right to exchange an agreed amount of currency on a certain date or in a certain predetermined period. These contracts are concluded by both parties outside the stock exchange and they themselves also set the terms of how the trade will take place.

Futures on the forex market

The last one mentioned is currency futures trading. More precisely, it is a futures market that works similarly to the forward market. Here you also enter into contracts with the other party, which oblige you and the other party to sell or buy one currency for another, at a precisely specified date in the future. However, unlike the previous type of market, contracts are legally binding. They are not closed off-exchange and are regulated by the Chicago Mercantile Exchange ( CME ).

How does the Forex market work?

Forex does not have specific places where trading takes place, as is the case with stocks or commodities. It is traded worldwide online, with an agreement being made directly between two parties in the OTC market. The largest currency centers can be found across time zones. These include Sydney, London, Tokyo and New York. This brings one big advantage. Forex is open 24 hours a day, so you can trade when you have the time and desire. Of course, except on weekends when the forex market is closed. Trading here is therefore time flexible.

The downside to this is that due to its size, Forex is hardly regulated. The fact that it is over-the-counter trading also contributes to this. So there is no authority to monitor the transactions made 24 hours a day. However, there are certain institutions that oversee compliance with certain standards. They are national institutions that are spread all over the world. For example, in Australia the forex market is regulated by the Australian Securities and Investments Commission (ASIC).

Forex and CFD trading

Traders can trade in the foreign exchange market through a broker or create an account in a bank. We have already talked about the fact that when it comes to traders who want to make money in Forex, they will not realistically want to take cash. They will be interested in profiting from the fact that they correctly speculated about the rise or fall of the given currency. In this case, it is trading with  CFD , i.e. contract for difference.

In this way of trading, you use financial leverage. It looks like you only own part of the price of your order at a given moment and the resulting profit, but also the loss, is subsequently multiplied. How many times depends on the size of the lever. The initial deposit you make is called margin. It is usually expressed as a percentage, depending on how much of the total price of your order the margin represents. For example, if the margin is 1%, you have put in 1% of the price of your order.

Forex is normally traded in lots. 1 lot is 100 thousand units of the given currency. Currently, however, you can enter the currency market with a smaller unit, for example with minilots, which is equivalent to 0.1 lot, or with microlots, which have a value of 0.01 lot. This happens thanks to the leverage system, which allows Forex traders to invest only a part of the price of the trade.

Who moves the exchange rate?

As a Forex trader, you will be interested in pips when you monitor the movement of the exchange rate in a currency pair. It is a unit that shows how the currency rate moves in a given pair, and usually has a value of a single digit to the fourth decimal place. The fact that you can find currencies from all over the world can make it difficult to estimate future developments. Therefore, it is necessary to monitor global events, and not only the economic ones, which can affect the ratio between supply and demand. There are many factors that affect the movement of currency pairs.

One such actor is the central banks of individual countries, whose tools allow them to set the price of one currency against others. Another important point is news from the world, not only economic but also political. Economic entities, including commercial banks, tend to invest in the currency of a state that is politically stable and at the same time has a promisingly developing economy. Any new, especially unexpected news, can sway such investments.

Traders themselves behave similarly, and by predicting the future development of the market, they can cause an increase or decrease in demand. This happens especially with investors who trade with brokers supporting the wisdom of the crowd or social trading, when actors can monitor the activities of successful traders in real time and imitate their behavior.

Forex market players

As we have already mentioned, there are a large number of entities on Forex, including banks, companies and individuals, who are trying to make money from foreign currency trading. Let’s introduce the most important of them one by one:

Central Banks and Forex

We have already imagined central banks as entities that significantly move currency rates. This is because they are tasked with maintaining monetary stability in their country and have a large number of tools to do so. Among the most important ones is the interest rate. Then there is the fact that they control the money supply that is in circulation in that country.

Trading companies and multinational corporations

These organizations enter the foreign exchange market in order to exchange their currency for the currency of the country with which they do business. And international trade was the reason for the creation of Forex. These companies offer, or demand, services and goods from abroad. And for that they need to exchange domestic currency for foreign currency.

Brokers and Forex

Brokers ensure the course of business between two parties. However, if you decide to trade, whether on Forex or anywhere else, choose your broker carefully.

Commercial banks

Commercial banks are also entering the Forex market. They trade either for themselves or for their clients. So you don’t have to trade on Forex only through a broker, but also through an account in a commercial bank.

Advantages and Disadvantages of Forex Trading

Similar to other markets, Forex trading also has its pros and cons. Let’s start with the positives. A big plus is that you can trade on Forex practically non-stop, except for weekends, from anywhere in the world. So it doesn’t matter if you are bored at home behind the stove or enjoying your vacation in the Maldives. You can follow the development of the movement of forex currency pairs anytime and anywhere.

Another major plus is that you don’t need too much cash to enter this market, thanks to the leverage system mentioned above. In addition, it can increase your profit several times. So if you are successful. And in order to be successful, we recommend that you first try one of the demo accounts offered by many brokers. You get that imaginary currency with which you can try Forex trading without the risk of losing your real money. At the same time, it is possible to sign up for any educational program, of which there are also plenty among brokers.

As for the disadvantages, financial leverage dominates here again. Trading is always a risk and Forex is no exception. Leverage can multiply not only your profit, but also your loss. So you should handle it with care, especially at first. Another disadvantage is the inability to adequately regulate Forex due to its size and global reach.

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