What Is Forex Trading?

Veteran stock traders might know about pairs trading. Pairs trading involves taking a bullish position in one stock or index paired with a bearish position in another, essentially trading the value of one security relative to that of another.

The forex market is another way to access pairs trading. In Forex, however, traders use currency pairs, which essentially is trading the value of one currency relative to that of another currency. Each currency pair is the ratio of one currency's value to another currency's value.

Forex trading takes place in a dynamic, global market that is open virtually around the clock. Because foreign exchange rates are based on global interest rates as well as macroeconomic and geopolitical conditions, they're always fluctuating.

The forex market is not conducted on an exchange, which means there is no physical location where all currencies trade.

Before considering trading forex, here are some basics every trader should understand:

• Leverage: Forex trading involves leverage, meaning traders can take a position in a larger investment with a relatively small amount of initial capital. This allows for strong potential returns, but traders should be aware that it can also result in significant losses and losses greater than your initial investment.
• Nearly 24/6 market: Traders need to be responsive to market conditions and economic events knowing that they can trade almost 24 hours per day, 6 days per week, from Sunday to Friday.
• Liquidity: Forex is a very active market with an extraordinary amount of trading, especially in the major currencies. Trading more obscure pairs may present liquidity concerns.
• Trading: Forex currency pairs are traded in increments of 10,000 units, and there is no commission. However, the cost of the trade is reflected in the bid/ask spread.

One way to think of a country's currency is similar to the way equity investors think of stocks. Higher stock prices typically (but not always) reflect investor confidence in a company's future. Likewise, higher currency values typically reflect investor sentiment in the health of that country's economy relative to other countries. Interest rates and interest rate differentials are one way to measure relative economic strength between countries. As rates or yields rise in the United States, banks and other investors might move money out of places that offer lower yields. For instance, if rates are low in Japan, investors might consider investing in what might be higher-yielding U.S. government bonds.

Capital movements across borders can be powerful forces that drive currencies higher and lower. Economic data and interest rates are two key fundamental drivers for this capital movement.

A forex trader buys one currency while selling the other. For example, a trader buying the EUR/USD pair is long the euro (EUR) and short the U.S. dollar (USD). And the rate is simply the ratio—the numerator over the denominator. Other actively traded pairs include USD/JPY, GBP/USD, USD/CAD, AUD/USD, and NZD/USD. Major currency pairs consist of any two of the following currencies:

• USD: U.S. dollar
• JPY: Japanese yen
• EUR: Euro
• AUD: Australian dollar
• NZD: New Zealand dollar
• CAD: Canadian dollar
• GBP: British pound
• CHF: Swiss franc

All other currency pairs are considered "exotic."

The minimum price movement in the forex market is called a pip. For example, if the quote for EUR/USD is 1.4168 bid to 1.4170 ask, and one pip is 0.0001, the difference in price between the bid and ask is two pips. Like stocks, forex traders buy at the ask and sell at the bid.

For many currencies, the pip is equal to 1/100 of a cent, or 0.0001, except for JPY pairs where the pip is equal to 0.01. For a $100,000 trade, a pip usually equals $10. A trader who captures 10 pips on such a trade makes $100. Conversely, by losing 10 pips on a trade, a trader loses $100. The ultimate value of a pip is determined by the size of the trade and the currency pair being traded. Retail forex traders can trade in increments as small 10,000 units.

For example, if a trader bought 20,000 units of AUD/USD, each pip would be worth $2 (20,000 x 0.0001 = $2). If a trader bought 20,000 units at 0.7126 and sold them at 0.7118, an 8-pip loss, they’d have lost $16.

In forex trading, margin requirements vary as a percentage of the notional value. Margin requirements at Schwab are typically between 3% and 5% of the notional value, although certain pairs can be as low as 2% or higher than 5%. Leverage can magnify losses as well as profits. A small amount of market movement can have a large effect—positive or negative—on an account's profit and loss¹ (P&L).

A trader should carefully consider and assess their risk tolerance before considering trading forex. Many of the same analysis techniques used for equities, like indicators used to trade stocks, futures, or options, can also be applied to forex charts. Even simple trendlines can potentially be useful when looking for the next major trend in a currency pair. However, traders should consider that past performance is no guarantee of future results. With technical analysis² and charting—prices fluctuate, and the charts follow the action (see image below). Note that while technical analysis can provide insight, it shouldn't be the only tool used to evaluate trades, as trends can change at any time. Traders should consider using various analytical tools to make decisions.

Trading currencies can also provide portfolio diversification. It's another asset class and another opportunity to initiate positions to build a portfolio. For example, an investor's stock portfolio might not be doing well, and some of the losses might be offset by positive results from a profitable currency position. However, forex trading also has its own risks, and diversification does not guarantee against investment loss.

Before deciding to engage in forex trading, it's also important to understand the risks. For example, the interest paid on a short currency could add up and reduce the value of a position.

Additionally, the leverage involved can lead to losses that are greater than the amount of your original investment. Due to the dynamic nature of currency markets, the situation can change quickly, affecting the value of a position and resulting in unexpected losses. Before starting, it's important to understand your personal risk tolerance and acknowledge the potential losses.

The forex market offers both short- and long-term potential trading opportunities. For example, an investor focused on fundamental factors, such as interest rates and economic data, can trade on information from news releases in search of short-term profits or even intraday moves. Economic news releases tend to cause very short bursts of activity in the financial markets, including volatile moves in currency pairs.

To start trading forex with Charles Schwab Futures and Forex LLC, traders need to open a standard brokerage account. The brokerage account can either be an individual, joint, corporate, LLC, trust, partnership, or sole proprietorship. The brokerage account needs to  be approved for margin privileges. Once the brokerage account is opened and enabled for margin privileges, traders can then apply for forex.

Once approved, traders can use thinkorswim to monitor the forex market, plan strategy, and implement their forex trades.

Forex trading privileges are subject to review and approval by Charles Schwab Futures and Forex LLC, a CFTC-registered Futures Commission Merchant and NFA Forex Dealer Member. Not all account owners will qualify.

Charles Schwab Futures and Forex LLC is the counterparty to all forex customer trades, and exclusively uses straight-through processing such that it automatically (without human intervention and without exception) enters into the identical but opposite transaction with another liquidity provider (creating an offsetting position in its own name).
 

Forex traders should also understand how interest rates could impact their P&L when holding positions through the close of trading from one trading day to the next. Forex trading creates a situation where a trader is essentially holding one long currency and shorting the other currency in the pair. A trader can earn interest on the long currency and pay interest on the short currency when keeping a position from one trading day to the next. The differential between the two interest rates amounts to what's called the "net financing rate." Depending on the situation, the net financing amount could increase or decrease the value of a position.