Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.
Updated on Monday, February 11, 2019
The currency markets are some of the most dynamic and high-volume in the world. More than $5 trillion trades hands every day, and currency markets are open 24 hours a day, five days a week, starting Sunday afternoon and running through Friday afternoon.
Here’s what you should know about trading forex, how to invest in the currency markets and whether it’s right for you.
What is forex trading?
Forex, short for foreign exchange, is the trading of currencies, and it takes place in the over-the-counter market or in negotiated transactions between counterparties, such as central banks. In the over-the-counter market, no exchange is involved, and a buyer and seller agree to a purchase price. Currency also can be traded through regulated futures and options markets.
In forex, traders use one currency to buy another, agreeing to an exchange rate for the currency pair. Like any other traders, forex traders are looking to sell the base currency later at a profit, exchanging it back to the counter currency or into another currency that looks attractively priced.
Forex brokers typically allow traders to highly leverage their equity, and it’s not unusual to see leverage of 50 times up to even 400 times the account’s equity. For example, at 100:1 leverage, a trader can buy $100,000 of currency with just $1,000 in equity. So a 1% upswing in the price doubles the trader’s equity. Of course, a 1% downswing wipes out the trader’s equity. However, many brokers limit leverage to 50:1, allowing customers to buy up to 50 times their equity.
In the United States, the currency market is regulated by the Commodity Futures Trading Commission (CFTC), an independent government agency, and the National Futures Association (NFA), a self-regulating industry group. But they regulate the futures and derivatives markets, not the spot market, where much of the trading in forex takes place. The spot market remains unregulated.
Foreign exchange markets explained
Currency trades are always grouped into pairs. For example, a typical trade might be EUR/USD, which is the pair for the euro and U.S. dollar. In this example, the euro is called the base currency, while the dollar is the counter currency. Currency quotes go out to four decimal places, and the first currency is priced in terms of the second currency. For example, the quote for EUR/USD might be 1.1503. This quote means that it costs $1.1503 to purchase one euro.
The standard unit in a forex quote is a pip, an acronym for percentage in point. Because forex brokers quote currencies to four decimal places, it’s convenient to have a term for this fourth digit, and that’s the pip. This is true except for transactions involving Japanese yen, where it’s the second digit past the decimal.
Currency trades are typically placed in lots that are sized as follows:
- A micro lot: a trade for 1,000 units of the base currency
- A mini lot: a trade for 10,000 units of the base currency
- A standard lot: a trade for 100,000 units of the base currency
Brokers will specify the minimum lot size that they will allow you to trade. The minimum often is a micro lot, though some brokers have no minimum size.
The most common way to trade forex is to buy the base currency with counter currency. But more advanced traders often use derivatives such as futures and options to gain exposure:
- Options give you the right, but not the obligation, to purchase a currency at a specified price by a certain date in the future. You can sell the option before it expires.
- A futures contract obligates the buyer to purchase the currency if the contract is held to expiration, but it can be sold up until that point to avoid that obligation.
What are some major currency pairs?
There are seven major currency pairs, and the U.S. dollar is on one side of each one. These seven pairs comprise about 85% of all trading volume. In fact, the dollar participates in about nine of every 10 trades that takes place. The major pairs include:
- EUR/USD: the euro against the dollar
- USD/JPY: the dollar against the Japanese yen
- USD/CHF: the dollar against the Swiss franc
- USD/CAD: the dollar against the Canadian dollar
- GBP/USD: the British pound against the dollar
- AUD/USD: the Australian dollar against the dollar
- NZD/USD: the New Zealand dollar against the dollar
Besides major currency pairs, there are also minor pairs and the exotics — currencies from emerging markets — both of which have a much lower volume of trading.
To measure the strength of the dollar, traders look at the U.S. Dollar Index, a weighted basket of currencies. It’s a quick gauge of the dollar against the currencies of some major trade partners, primarily the E.U., the U.K., Japan and Canada. Sweden and Switzerland are also part of the basket. When the index rises, the dollar is stronger, meaning it buys more foreign currency.
How to trade forex
The big brokers that dominate stock and bond trading are not always present in the forex markets — though a couple are — but more specialized brokers fill the gap. Whether you go with a traditional or specialized broker, it’s easy to set up an account and start trading quickly, and the process is similar to establishing a stock brokerage account.
If you’re looking for a forex broker, you’ll want to consider the following characteristics:
- Leverage: How much margin will the broker allow you?
- Commissions and fees: How does the broker get paid — through a markup on the forex spread or via a straight fee?
- Minimums: What’s the minimum account size, and what’s the minimum trade size?
- Currency pairs: How many pairs does the broker offer?
- Spreads: How wide are the broker’s spreads? The narrower, the better.
In particular, you should pay attention to a broker’s spreads and how they may affect your trading costs. Wider bid-ask spreads can increase your costs, and many brokers will factor your trading fees via a larger spread instead of charging a fixed fee as in stock trading.
For example, let’s say you want to buy 10,000 euros using the EUR/USD currency pair and you pull up a quote on your broker’s site. The bid for euros is 1.1797, while the ask is 1.1799. Sometimes this quote is abbreviated as 1.1797/99, with only the latter two digits quoted. To buy the base currency (euros here), it will cost you 1.1799 units of the counter currency (dollars here).
In this case, since you’re buying 10,000 units, you simply can move the decimal four places to the right, and the total transaction costs $11,799.
Sometimes brokers even quote spreads lower than a pip, breaking down the spreads into one-tenth of a pip. That’s even better for traders whose trading fee is a spread markup since it potentially narrows their costs further.
There are other ways to play forex without going into the forex markets directly. There are specialized exchange-traded funds (ETFs) that allow you to gain exposure to the major currencies and some of the minor ones. Mutual funds also offer currency exposure.
But investors shouldn’t forget that they may already have currency exposure, albeit indirectly, through their stock investments. Major multinational companies derive a huge portion of their revenues from outside the U.S., so their profits usually are already exposed to forex and can move higher when the dollar weakens and vice versa.
What are the risks?
Like any kind of trading, forex comes with its own specific risks. Here are some of the major risks for forex traders and what each means:
- Leverage risk: Just like in other kinds of trading, leverage in forex can magnify the movement of a currency. That means gains can become increased, but so can losses. With leverage of 100:1, a 1% swing in the currency can double your profit — or your loss. Because of the common use of leverage in forex, it’s important to manage your position size and risk so you can live to trade another day.
- Political risk: Currencies move for many reasons, but one of the most important is the actions that governments take. A move that is perceived as negative for growth can cause a currency’s value to plummet, as businesses and consumers need the currency less. The U.K.’s 2016 decision to explore leaving the European Union — also known as Brexit — was perceived as highly negative, and the value of sterling dropped in subsequent months. Markets are constantly looking for unstable situations and will discount currencies accordingly.
- Interest rate risk: All else equal, higher interest rates generally cause a currency to increase in value and vice versa. So when a country’s central bank changes interest rates — especially unexpectedly — or an economy heats up, it can affect how the currency trades. Economies that are growing faster will tend to have higher interest rates, and traders are watching for the relative change in rates in the target countries, not just the absolute level of interest rates.
- Devaluation risk: A country’s central bank can decide overnight if it wants to devalue its currency, making it worth less vis-a-vis other currencies. A country might devalue its currency slowly over time or in one swoop, and it might do so in order to increase its exports or to reduce the real cost of interest payments on its debt.
- Exchange rate risk: The forex market can move for fundamental reasons (such as a country devaluing its currency) or for technical reasons (not enough buyers or sellers in the market at a given time). Whatever the cause, traders have to bear the risk that exchange rates will fluctuate, even if the cause is not always clear.
Is forex trading right for you?
Trading forex is not for everyone. With 24-hour markets and the presence of massive players in the market — who can shift trading in the market at their command — it can be tough to be a forex trader.
Also out in the forex market are the following players, each with its own agenda:
- Central banks: Central banks, such as the Federal Reserve in the United States, can affect the forex markets both directly and indirectly. Their goal is to create economic growth and price stability in their country. Indirectly, central banks set short-term interest rates, which can have follow-on effects in exchange rates. Directly, central banks also can use their domestic currency to buy and sell foreign currencies.
- Governments: Governments often seek to manage how their currency trades and can intervene directly in the market by buying or selling currencies, perhaps intending to keep the currency strong or weak. They also can devalue their currency.
- Banks: Banks are among the largest traders in forex markets. They may trade forex among each other, trade to make a profit for their own account or facilitate transactions on behalf of their corporate customers.
- Professional speculators and traders: These players may include hedge funds and other investment managers, all of whom are trading to make a profit. These traders may take a position in a currency to hedge an investment’s exposure to a specific currency.
- Companies: Huge multinational companies use forex markets to offset exposure to specific currencies. For example, if a company builds products in one country and sells them to another or many others, then it’s exposed to currency risks. The company might want to offset some of this exposure, especially if there are expectations that currencies will move and affect the company’s profitability.
- Individuals: Individuals are a relatively small portion of the forex markets, and they’re trading to make a profit for their own account.
Against this backdrop and multitrillion-dollar daily volume, individual traders should carefully calculate whether they want to trade forex. Competitors are huge and can move the market — and, importantly, have motives other than making money. So they take actions that can be completely antithetical to profit, especially yours. These players also are well-informed and know the macroeconomic landscape or at least have access to well-placed advisors who do.
So these elements all can make it difficult for individuals to succeed in the forex market. Traders need to follow and understand the macroeconomic news and reports, and with the markets trading 24 hours a day, new developments can happen at almost any time. Of course, these skills are on top of having the trading expertise to make a go of it.
Some traders can do quite well at trading forex, but currency is not a buy-and-hold kind of asset for long-term investment. Rather, it’s a trader’s game, with active moves in and out of the market, and you really have to stay committed to the practice.
That’s why many individual investors leave forex to the professionals and stick to tried-and-true investing in the stock market. (Here’s how to get started investing in stocks, which have a solid track record.)