Foreign Exchange (Forex) Currency Trading Basics

The foreign exchange (forex) market has a daily trading volume of more than $6 trillion and is available nearly 24 hours a day, six days a week.

Forex rates are what it costs to exchange one country's currency for another country's currency. Additionally, the forex market keeps the global system of imports, exports, and payments in balance—from home goods to portfolio investments.

Before starting, it's important to understand that forex trading is subject to unique risks and isn't suitable for everyone. It takes time to understand how the product is traded and quoted. Currency trading on the forex market involves trading two currencies against each other, otherwise known as a pair. The quote for a forex currency pair references what it costs to convert one currency to the other.

For example, say the U.S. dollar (USD) and Canadian dollar (CAD) (USD/CAD) pair is trading at 1.34. In this scenario, $1 USD is equal to 1.34 CAD. The easiest way to understand the quote of any currency pair is to read the pair from left to right. For example, if the euro and USD (EUR/USD) pair is trading at 1.09, that means 1 euro is equal to $1.09 USD.

Like other asset classes, currencies fluctuate for reasons like interest rates, inflation, economic growth, and future expectations. However, fluctuations in a currency are volatile as they are also relative to the same dynamics in the other half of the currency pair.

One example is from June 2016 when Britain voted to leave the European Union. The British pound (GBP) dropped from about $1.50 relative to the USD to below $1.30 within a week. The Brexit vote lowered growth and interest rate expectations among many investors. Meanwhile, the United States had begun hiking its interest rates a few months earlier. So, relatively speaking, market participants saw the dollar and dollar-based investments as having a higher return profile than those based in pounds, and the exchange rate adjusted accordingly.

Exchange rates react to economic data, meetings, and speeches by central bankers, as well as anything that might affect relative expectations of growth, interest rates, and inflation among nations and their currencies.

The bulk of forex rate trading takes place in what's called the "interbank market," which is an over-the-counter (OTC) market that is not traded on an exchange. The interbank market consists of banks, dealers, and intermediary brokers.

Retail participants, in general, don't have direct access to the interbank market, but the price information is used by retail platforms offering forex trading. These platforms are retail forex brokers and are generally compensated through the bid/ask spread.

The major currencies, such as the dollar, euro, pound, and yen, usually have tight spreads, but the spreads can fluctuate during the day. Some of the more obscure pairs (called "exotics") may have wider spreads than the major pairs. Additionally, forex trading involves leverage, which means traders can establish a position in a large investment with a relatively small amount of money, which could potentially lead to magnified profits. However, leverage can compound losses as well.

There's also a futures market for currency trading. It's made up of exchange-traded, standardized contracts for future delivery of several major currencies versus the USD.

Futures contracts can be similar to forex trading because they allow traders to establish a position in a large investment with a relatively small amount of money. However, one difference in trading forex is the ability to control the size of the position you invest in. Forex can be traded in 10,000, or 100,000 lot increments, while the futures market uses a standardized contract with a defined size that may not offer the same flexibility as forex.

The foreign exchange market can potentially offer traders international exposure and long-term or short-term opportunities in cross-border interest rate differentials; however, it's important for traders to do their homework to understand the pros and cons before considering trading forex.