What is Forex and Forex Trading?

ByDawn Pipkin

May 28, 2022

Traders should understand what is forex before learning how to engage in forex trading. Forex is short for foreign exchange, which is the global marketplace in which traders can purchase, sell and exchange different currencies. Forex trading is when one currency is exchanged for another, and currencies are traded in pairs.

The forex market consists of major currency pairs, minor currency pairs, and exotic currency pairs. The forex market has several unique qualities that make it appealing to traders. For example, traders can borrow a significant amount of leverage from firms as a tool to enhance their positions. The forex market is also the most liquid and traded at a high volume. Finally, the forex market contains less regulation than other markets.

What is Forex?

Understanding the basics of what is forex is critical to trading in the forex markets. The major players or participants who trade currencies in the forex market are banks, hedge funds, investors, and central banks. Additionally, global firms can use the forex market to hedge currency risk when they conduct foreign transactions. Currency risk is the risk traders incur when they could potentially suffer losses from a price change of one currency to another in an unfavorable way.

The forex market has the highest volume of trading of any market and operates 24 hours a day. The market is only closed on weekends. When one financial center closes, another hub continues to stay open for business. The sessions are separated into the Sydney session, the Tokyo session, the London session, and the New York session.

Explaining Forex begins with some of the unique features that answer the basic question: what is forex. Since the forex market essentially never closes and there is a high volume of trading, it is an extremely liquid marketplace. Traders can buy or sell a currency pair without significantly changing the exchange rate of the currency pair. There is a significant amount of trading in that currency pair, which means there are typically willing buyers and sellers.

What is Forex Trading?

Traders should understand what is forex trading before starting to execute trades in the forex market. In forex trading, investors buy one currency and sell another, thus trading currency pairs. To understand what is forex trading, people should understand the goal of forex trading.

Traders aim to long the currency that they anticipate will appreciate relative to the other currency, which they sell. The price movement of a currency pair is measured in pips. A pip, or percentage in point, is the movement of one unit of the fourth decimal point in an exchange rate (with some exceptions).

Types of Currency Pairs in Forex Trading

There are several types of currencies to trade. The most liquid and highly traded currency pairs are called the majors. Seven currencies make up the major currencies, and these currency pairs include EUR/USD, USD/JPY, GBP/USD, and USD/CHF. These currencies make up 85% of trades in the market, and all pairs contain the US dollar.

Another type of currency pairs is called minor or cross pairs. Minor currency pairs include any two major currencies aside from the dollar. The third type of currency pair is the exotic currency pairs. Exotic currency pairs include one major currency, which is paired with an emerging market currency. An example would be USD/HKD.

More Unique Features of the Forex Market

Leverage is used as a key tool among traders in the forex market. Leverage in the forex market is the highest of all markets. The way leverage works is that traders can borrow money from a firm while putting up a small initial deposit. Leverage enables traders to significantly boost their position size. Although traders can make huge gains from using leverage, they run the risk of suffering immense losses, as leverage cuts both ways. In the forex market, leverage is commonly as high as 100:1, which means that a trader that has $1,000 in their account can take on a position of $100,000.

Leverage in the forex market is high because of the high liquidity in the markets. Since traders can enter and get out of their positions easily, they likely will not suffer huge losses if the market turns out of their favor. Also, traders in the forex market can manage their risk more effectively than in other markets if they manage their accounts well. Still, that is not to say that there is less risk associated with forex trading. It’s important to be sure you enter the markets with enough skill and confidence.

Less Regulation Differentiates the Forex Market from Other Markets

Spot foreign exchange, which is an agreement between two parties to buy and sell at the spot rate, is not regulated by a central body, and there are no clearinghouses. Fewer rules mean that traders pay fewer commissions and fees than in other markets. Still, you’ll notice that many forex brokers are regulated, which means they abide by the high standards of conduct and quality as dictated by a certain regulatory commission, and thus provide a more secure trading environment for forex clients.

The Bottom Line

The forex market is made up of currency pairs on which a trader speculates on the direction of one currency relative to another. Global corporations use the forex market to hedge their position in foreign currencies when they want to mitigate currency risk. There are major currency pairs, minor currency pairs, and exotic currency pairs. The price movement of one currency pair relative to another is measured in pips, which is the movement of one unit of the fourth decimal point in an exchange rate.

Traders should be aware of several unique features of forex trading. Traders can use leverage as a tool to enhance their positions, but they should be aware of the downside risk that could come with borrowing a large amount of leverage. The significant amount of leverage in the forex market is a function of a large amount of liquidity and volume traded in the forex market. Additionally, there is less regulation in the forex market, which enables traders to avoid commissions and fees. Still, it’s advisable to choose a broker which is regulated to ensure a safer, more secure trading environment.

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