What is Forex? A Beginner’s Guide (2024)

Forex, or the foreign exchange market, is the largest and most liquid financial market in the world, bringing together individual traders, financial institutions, and central banks and giving them a chance to buy, sell, and trade a large number of global currencies.

In this guide, we will examine what Forex is, how it came to be, what sets it apart from the stock market, and how it works.

What is Forex?

Forex is decentralized, meaning that all transactions are completed via computer networks among traders themselves and not through a bank or another sort of financial institution or exchange.

The market is also available 24 hours a day (except during the weekends), as it is conducted by four global sessions in London, New York, Tokyo, and Sydney.

What is Forex trading?

Forex trading, also known as foreign exchange trading or currency trading, is the process of buying and selling currencies. Typically, this is done with the goal of making a profit from the fluctuations in their exchange rates.

Some of the more widely used Forex trading strategies are:

• Scalping: Scalping is a short-term trading strategy that involves multiple quick trades that help traders profit from small price movements within a short period of time. Some forex brokers can restrict this trading strategy, as it is not widely allowed by the FX platform;
• Day trading: Day trading is similar to scalping. However, it involves actively buying and selling securities within the same day and not, for example, on an hourly basis;
• Swing trading: Swing trading is a short-to-medium-term trading strategy involving trades that can last from a couple of days to a few months.

Forex trading carries significant risks, and losses are just as likely as gains. Trading requires a good understanding of the market, risk management techniques, and careful decision-making.

Who trades Forex?

As the Forex market is decentralized, and there are various kinds of traders participating in it. That includes anyone, from individual retail traders to commercial banks.

The major players in the forex market include:

• Commercial banks: Commercial banks can trade on their own behalf or enable their clients to participate in the market. Due to the capital at their disposal and their infrastructure, commercial banks are the key player in the Forex market;
• Central banks and governments: Central banks and governments are perhaps the second most important link in the Forex chain. Central banks can implement monetary policies and thus greatly affect the status of a national currency. They can also manage inflation and hold reserves. Governments, on the other hand, engage in trading to manage their trade imbalances, implement foreign exchange policies, etc.;
• Retail traders: Retail or individual traders participate in the market on their own behalf through various online brokers and platforms, such as MetaTrader 4 (MT4) and MetaTrader 5 (MT5);
• Trading firms and non-bank financial institutions: Brokerages themselves can participate in Forex trading, and so can insurance companies and other financial institutions. Often, proprietary trading firms allow users to trade using their capital or trading tools. In turn, the user makes money by receiving a share of the profit they made with the company’s capital.

The history of Forex

The main principle on which Forex dates back a long time, to prehistory, when goods and services were exchanged between various parties directly. Introducing more convenient payment methods, such as coins and bills, and the gold standard, allowed traders to establish a common unit of value and trade more efficiently.

The idea of Forex, as we know it today, started to form in the 1800s and early 1900s. It was then that the gold standard gained more prominence, allowing units of account and the value of currencies across the world to be based on a fixed amount of gold. This stability meant that currencies could be exchanged at a fixed rate.

In 1944, with the signing of the Bretton Woods Agreement, new rules were established for commercial and financial relations between some of the world’s major political players, namely, the United States, Japan, and some Western European countries. The new rules guaranteed foreign currencies could be exchanged for the US dollar within 1% of fixed parity rates. In turn, the US dollar could be converted to gold at fixed rates as well.

This system worked until the early 1970s when the US dollar could no longer be converted into gold, as decreed by the US government. That led to a drastic change in the global market. Most notably, it transitioned to a free-floating system where currencies were valued based on supply and demand. In the 1990s, with the advent of the internet and digital technologies, the market became available to individual brokers.

What are currency pairs in Forex?

Currency pairs, also known as Forex pairs, are the financial instruments traded in the foreign exchange market. A pair consists of national currencies from two countries coupled together. Each currency has a fixed exchange rate, meaning that a pair represents the relative value of one currency compared to another. All Forex trades are made using currency pairs.

In theory, any national currency can participate in the thread. However, some currencies are more frequently traded than others, and all primary pairs revolve around the US Dollar. Those that do not are called cross-currency pairs, and they usually involve the Euro or the Japanese Yen.

Some more commonly traded primary pairs include:

• Euro (EUR)/ US Dollar (USD);
• US Dollar (USD)/Japanese (Yen);
• British Pound (GBP)/US Dollar (USD);
• US Dollar (USD)/Canadian Dollar (CAD);
• Australian Dollar (AUD)/US Dollar (USD).

Leverage and margin in Forex

No matter who is engaging with the market, Forex leverage and margins are always among the most important factors that allow traders to control their positions.

• Leverage: In principle, leverages allow users to borrow money and thus increase their trade sizes in comparison to their available funds. The higher the leverage, the more users can borrow from their broker. Naturally, high leverages can lead to bigger profits, but they come with exponentially larger risks;
• Margin: Before opening a trade, users need to allocate a portion of their trading position as collateral upfront. That is, as a deposit that might cover some of the risks the trader incurs for the broker. This percentage is called the margin.

Forex vs. stocks differences

Forex and stocks are often discussed together, and are interconnected in many ways. For example, fluctuations in Forex exchange rates can potentially impact the profitability of a business, affecting stock prices of companies involved in international trade. In addition, if stock market analytics predict higher chances of profit, investors may sell currencies to buy stocks instead, potentially affecting Forex exchange rates.

However, there are some insurmountable differences between them. They boil down to the following:

• Trading volume: Forex is much larger than the stock market. In terms of sheer numbers, the daily stocks trading volume is comparable to the hourly Forex trading volume. That makes Forex trading a more attractive option for those with large capital;
• Liquidity: Higher trading volume implies higher liquidity, which, in turn, leads to lower transaction fees;
• Market hours: The stock market is not open 24 hours, as it usually closes around 4 pm eastern time;
• Commissions: There are often no commissions at Forex brokers. Instead, they make profits based on the differences between buying and selling prices. However, some brokers, such as OANDA, offer various pricing plans. That allows traders to pay fixed commissions on a per-trade basis or include them in their spread prices. You can learn more about this broker by reading our comprehensive OANDA review.

Forex risk management

Trading can be risky, and the market is often volatile. Therefore, traders usually implement some safety strategies to minimize risk and mitigate losses. Brokers often do the same thing, making their platforms more attractive to new users. The key components of Forex risk management include:

• Stop loss orders: Traders can demand that brokers automatically sell an asset when its price reaches a particular limit, which is called a stop loss order;
• Diversification: Allocating all of one’s resources to a single asset is dangerous. Forex traders usually spread their investments across different currency pairs to mitigate the risk of market fluctuations not going in their favor;
• Constant evaluation, analysis, and monitoring: A successful trade is a result of a well-informed decision, so market monitoring, research, and analysis are crucial, especially when trading strategies need adjustments.

Final thoughts

As the world’s largest financial market, Forex offers various opportunities to traders and investors. Due to its scope, however, extensive research and some risk management strategies are necessary to ensure a profitable trade.

Trading is inherently risky, and profits are not guaranteed. So, if you are a newcomer to Forex trading, you will have to arm yourself with realistic expectations, and of course, never invest what you cannot afford to lose.