How Does the Forex Market Work?

The foreign exchange market (Forex) is a global, decentralized market and is the world’s biggest financial market, with over $5 trillion worth of daily volume. Naturally, as the de facto reserve currency of the world, the US dollar takes up the majority of the transactions.

 

 

 

 

Forex trading is based on pairs, where one currency is valued relative to another currency. Many currency pairs have nicknames, such as “Cable” for GBP/USD and “Swissy” for the EUR/CHF pair.

 

 

 

 

 

How Does Forex Work?

Previously, the only time most people would think about currency rates would be when they were planning to travel abroad and needed to exchange some money. Other than central banks and large corporations, it just wasn’t on people’s mind.

 

Nowadays, forex is a very popular market for trading thanks to its low costs and access to high leverage. 

 

Let’s explore a bit more about how this market actually works.

 

 

 

 

The Interbank Market

 

 

The interbank is a network of banks that trade currencies and currency derivatives. These participants often deal directly with each other, but sometimes use electronic brokering platforms.

 

The interbank market for foreign exchange serves both commercial currency transactions as well as more speculative, short-term currency trading. 

 

Institutions and corporations usually transact on the foreign exchange market because they are importers or exporters, and need the foreign cash to close deals. Often, these larger players can also use the market to hedge certain currency risk. 

 

There are also lots of speculative transactions initiated on the foreign exchange market, by both large firms such as hedge funds, as well as the smaller retail traders.

 

Why Trade Forex?

The foreign exchange market is the largest market on the globe. In addition to convenient market hours, high liquidity, and margin trading capabilities, trading forex has many other benefits. 

 

In short, forex is the ideal market to trade for both retail and professional traders alike. Here are the 6 main reasons why:

 

  • Long & Short

 

 

FX trading gives you the possibility of profiting from either side of the market; no matter if prices are rising or falling. Since trading currency pairs inherently means you are always buying one currency and selling it against the another, every trade will see you both short and long at the respective currencies at the same time. 

 

Essentially, you can profit from any direction. The trick is figuring out which will be the strongest pair, and which will be the weakest.

 

  • 24 Hours

 

 

Forex is a global market, which means it is possible to trade at almost any hour on any day. 

 

There are of course specific sessions where more volume takes place, and this is usually split into 3 categories: Asian, London, and New York sessions. You can read more about this in our article Choosing a Trading Session to Trade.

 

The bottom line is, forex is a truly global market, so there will always be opportunities to trade, no matter where you are or when you have the time to trade.

 

  • Deep Liquidity

 

 

Foreign exchange is by traditional definitions the most liquid market in the world, with thousands of buyers and sellers looking to trade at all hours.

 

Since Forex offers such high liquidity, even large transactions can be completed with ease and with little to no impact on price. As a result, spreads and transaction costs are often low. For traders, this means they can speculate on even the smallest of price fluctuations.

 

  • Leverage

 

 

Leverage gives trades the ability to open positions on the forex market with only a small portion of the total value upfront (known as margin).

 

Margin is a double edged sword, since it can amplify gains as well as losses. It’s a great tool if you’re on the right side of a move, since you can make a large profit with very little cost. But it can be disastrous if you get caught on the wrong side, especially in a fast moving market. This is why it is vital for forex traders to accurately measure risk.

 

  • Volatility

 

 

With billions of dollars changing hands every minute, the price movements of some currencies are highly volatile due to the high volume of forex trades each day. Speculation on price movements in either direction can result in large profits. Risk-management tools help limit your exposure to volatility, which can rapidly turn against you.

 

  • Lot Size

 

 

Most currency pairs used standadized lots – batches of currency used to trade. Lots tend to be very large in forex because currency movements are small: a standard lot being 100,000 units of the base currency. This is one of the reasons why forex trading is so highly leveraged, but this is not usually the minimum trade size of most Forex brokers anyway, which usually also offer micro lots.

 

The advantage of lots is that they can be specific down to the tens of thousands, meaning traders can more precisely calculate risk and position sizing.

 

 

 

Conclusion

Foreign exchange is not traded on exchanges like most other markets, but rather directly between multiple parties. 

 

The major forex trading activity is spread out across four major forex trading centres spread across four time zones: London, New York, Sydney, and Tokyo. Since there is no central location, the forex market is open 24 hours a day.

 

The experienced traders of our Discord community often discuss currencies and their order flow action. Join the conversation for free today.

 

 

 

Receive updates about new articles

Follow us on social media

Unable to load Tweets

Learn More About Bookmap