What Is Forex? How the Currency Market Works, Explained From Zero

Forex is short for foreign exchange. It is the global market where currencies are traded against each other. Every forex trade buys one currency and sells another at the same moment, at a price called the exchange rate. Retail traders try to profit when the rate moves in their favour.

If you trade it, the part that matters most is how small price moves turn into money. A move of a fraction of a cent can mean a profit or loss of tens of dollars, depending on the size you choose. Work that number out before you click buy.

Forex is a market for swapping one currency for another

If you have ever changed money for a trip, you have already used forex. You handed over one currency and got another at the rate on the board. The market works the same way, on a much larger scale, with prices that change every second.

Several kinds of players trade it, each for their own reason. Banks trade for clients and for themselves. Companies pay for imports or bring foreign earnings home. Funds invest abroad, central banks manage reserves, and retail traders speculate through brokers. All of these orders end up in the same prices.

The Bank for International Settlements (BIS) measures the market in a survey every three years. Its figures put daily trading in the trillions of US dollars.

The US dollar is on one side of most trades, far more than any other currency, and the euro comes second.

Retail forex uses the spot rate, today's exchange rate.

Reading a currency pair: base, quote, bid and ask

Forex prices are always shown as a currency pair, for example EUR/USD. The first currency is the base currency. The second is the quote currency. Say EUR/USD shows 1.1000. That means one euro costs 1.1000 US dollars.

When you buy EUR/USD, you buy euros and pay in dollars. This is called going long. When you sell, you sell euros for dollars, which is going short. You do not need to own euros to sell. Selling is simply a position that profits if the price falls.

A common misread is "EUR/USD went up, so the dollar got stronger." It is the other way round. A rising EUR/USD means one euro buys more dollars: the euro gained against the dollar. Rule: the price is the value of the base currency. If it rises, the base gained. If it falls, the quote gained.

What a rising or falling EUR/USD price means for the euro and the dollar

Every quote has two prices. The bid is what you get when you sell. The ask is what you pay when you buy, and it is always the higher of the two. The gap between them is the bid-ask spread. Suppose the quote is bid 1.1000 and ask 1.1002, as in the chart below.

EUR/USD quote showing the bid, the ask and the spread between themIllustration

You buy at the ask, but to close the trade you sell at the bid. So every trade starts slightly in the red, by the size of the spread. The price has to move past that gap before you make anything.

How the forex market works without a central exchange

Spot forex has no single building or exchange. Large banks quote prices to each other in the interbank market. Your broker takes prices from one or more of these big dealers, or sets its own, and passes them on to you. The picture below shows that network. Notice that nothing sits in the middle.

Spot forex as a dealer network with no central exchange

With no single trading venue, two brokers can show slightly different prices for the same pair at the same second. Small differences like this are normal. They are also one reason the cost of a trade varies between brokers.

Dealers in different cities hand the market to each other as their day ends, so spot forex trades around the clock on weekdays. Trading follows the business day from Asia-Pacific to Europe to North America. The chart below shows the four main trading centres on a 24-hour clock. Sydney opens at 21:00 UTC the evening before, so it appears at both ends of the day.

Forex trading sessions on a 24-hour clock (approximate, UTC)

These hours are approximate. London, New York and Sydney shift by an hour when daylight saving time starts or ends; Tokyo does not change. The London–New York overlap is the busiest stretch, because the two largest pools of traders are active at the same time. More orders usually mean tighter spreads and faster price moves.

After New York closes and before Asia gets going, fewer dealers are quoting. Spreads often widen, and prices can jump because there are fewer orders. That is a poor time to open a trade on impulse.

Pips and lots: how a price move turns into money

A pip is the standard unit for measuring price moves. For most pairs it is the fourth decimal place, 0.0001. For pairs that include the Japanese yen, it is the second decimal place, 0.01. In the quote above, the 0.0002 spread is 2 pips. If USD/JPY moved from 150.00 to 150.02, for example, that would also be 2 pips.

Where the pip sits in a EUR/USD price and a USD/JPY price

A lot is the size of your trade, counted in units of the base currency:

You can work out pip value for any pair yourself: pip value (in the quote currency) = pip size × units. For one standard lot of EUR/USD that is 0.0001 × 100,000 = 10 US dollars. If your account is in dollars, you are done.

When the quote currency is not your account currency, you need one more step. One standard lot of USD/JPY gives 0.01 × 100,000 = 1,000 yen per pip. Divide that by the current USD/JPY price to get the value in dollars. Do this check once for every new pair you trade.

Worked example: one EUR/USD trade from start to finish

The figures here are an illustrative example. You buy 1 mini lot (10,000 euros) while EUR/USD shows the same quote as before: bid 1.1000, ask 1.1002. You buy at the ask, 1.1002. Later the quote is bid 1.1032, ask 1.1034, and you close by selling at the bid, 1.1032.

You did not need $11,002 to open this trade. The broker only asks for margin, a deposit set aside while the trade is open. Leverage is the ratio between the position size and that deposit. At 1:100 leverage, for a US-dollar account, the margin here is $110.02. The steps below show the arithmetic.

Profit on 1 mini lot of EUR/USD bought at 1.1002 and sold at 1.1032

Price move1.1032 − 1.1002= 0.0030

Move in pips0.0030 ÷ 0.0001= 30

Pip value, 1 mini lot10,000 × 0.0001= $1

Profit30 × $1= $30

Position value10,000 × 1.1002= $11,002

Margin at 1:100 leverage$11,002 ÷ 100= $110.02

Result of the trade+$30

Look at what the spread did. The midpoint between bid and ask moved from 1.1001 to 1.1033, which is 32 pips. You kept 30 of them. The missing 2 pips, $2, is the spread you paid by buying at the ask and selling at the bid. The picture below puts the opening and closing quotes side by side.

Opening and closing EUR/USD quotes in the worked example: buy at the ask, sell at the bid

Now suppose the price fell instead and you closed at a bid of 1.0982. The arithmetic is 1.0982 − 1.1002 = −0.0020. That is −20 pips × $1 = −$20.

Margin is not the most you can lose. Your profit or loss comes from the full 10,000 euros. Measure every loss from your entry price, 1.1002, to the bid you close at. A 110-pip move against you, measured from that entry price, would cost $110, roughly the whole margin. If your account holds more money, the loss can keep growing.

Loss on 1 mini lot of EUR/USD bought at 1.1002 as the price falls 20 and then 110 pipsIllustration

Spot, CFDs and futures: the three forms you will meet

The same exchange rate can be traded in different wrappers. A CFD (contract for difference) is an agreement with your broker to settle the change in price, without ever exchanging the currencies. The table shows how the three forms differ on the points that affect you.

Most retail accounts trade spot forex or forex CFDs. The prices, pips and lots in this lesson work the same way in both.

What makes exchange rates move

Exchange rates move with supply and demand. When more money wants to buy a currency than sell it, the price of that currency rises. Four forces drive most of that demand:

• Interest rates and central banks. Higher expected interest rates tend to draw money into a currency. That makes central bank decisions, and even hints about them, some of the biggest market events.
• Economic data. Reports on jobs, inflation and growth change what traders expect from central banks, so prices react within seconds of a release.
• Trade and investment flows. Companies paying foreign suppliers and investors buying foreign assets have to convert currency, sometimes in large amounts.
• Risk mood. In times of stress, money tends to move into currencies that are seen as safe, and out of currencies that are seen as risky.

Around scheduled news releases, prices can jump past several levels at once and spreads often widen. Even if you trade from charts, check the economic calendar before you open a position.

Mistakes that cost beginners money

Two terms first. A stop-loss is an order that closes your trade automatically at a price you choose in advance, so the loss cannot grow past that point. The stop distance is the gap between your entry price and your stop-loss price, counted in pips or in price.

• Choosing lot size by feel. Decide your maximum loss in money first, then work out the size. For a pair quoted in your account currency, the formula is units = maximum loss ÷ stop distance in price. Say you accept a $20 loss with a 20-pip stop: $20 ÷ 0.0020 = 10,000 units, which is 1 mini lot. If the answer is smaller than your broker's minimum lot, skip the trade instead of rounding up.
• Entering without an exit. Decide where you will take the loss and where you will take profit before you enter. Place the stop-loss order together with the trade, not after the price has started moving against you.
• Copying pip distances between pairs. A 20-pip stop on USD/JPY is 0.20, not 0.0020, and each pip is worth a different amount. Recalculate the stop and the pip value for every pair.
• Trading thin hours and live news. Check the time and the current spread before you enter. If the spread is much wider than usual for that pair, wait.
• Going live too early. Practise on a demo account until you can work out pip value and lot size without hesitating. Then start with the smallest lot size you can, using only money you can afford to lose.
• Chasing a loss. Doubling the size to win back a loss quickly is how small losses become large ones. Set a daily loss limit and stop trading for the day when you hit it.

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