Forex, or FX for short, refers to a global electronic marketplace for trading different countries’ currencies and derivatives of these currencies. The term itself is a portmanteau of the words “foreign” and “exchange.”
Lesson Highlights
- The forex market is the world’s largest market by volume size.
- Traders earn money in forex through the differences in the value of the currencies they are trading, selling, or buying.
- Buying, selling, or trading currencies is always done in pairs.
- Technically speaking, the forex market never closes. Instead, it moves from one region to another as each region’s business day opens and closes.
The Forex Market
Despite being the world’s largest and most liquid market (by trading volume), the forex market has no physical central location. Instead, the majority of trades are accomplished through third-party platforms, such as banks, brokers, and other financial institutions.
Forex markets operate 24 hours a day, five days a week (closed on weekends), except during holidays. Unlike stock markets, forex markets remain open during many holidays, though the trading volume may be subdued.
You may wonder how traders can access the forex market even during holidays. The answer lies in decentralization.
The forex market's decentralized nature and its major trading sessions make this virtually non-stop operation possible. At the end of a country’s business day, the forex market simply moves to another country where the day is just about to start.
The market starts daily in Auckland or Wellington, New Zealand, moves to Sydney, Australia, and crosses Asia (Singapore, Hong Kong, Tokyo) into Europe (Frankfurt and London), and then moves to North America (New York) before starting again in New Zealand.
On any given trading day, an average of $5 trillion is traded in the forex market – significantly larger than the equity market’s $200 billion daily.
How Does the Forex Market Work?
The forex market works like other trading markets. Traders can buy or sell currency pairs, with the market dictating the prices for each pair. Because currencies are always bought, sold, or traded in pairs in the forex market, the value of each currency in a pair is always relative to the other.
Forex traders classify a country’s currency as either “free float” or “fixed float.” Countries with free-floating currencies are those with currency values affected by free-market factors, such as supply and demand. Some examples of free-floating currencies include the US dollar, the euro, and the Japanese yen.
Contrary to free-float currencies, countries with fixed-floating currencies set their currency’s value relative to other currencies. These values are often fixed to widely recognized standards, such as the US dollar. Fixed-floating currencies still circulating include the Denmark krone, the Hong Kong dollar, and the UAE dirham.
How Do Traders Profit from Forex Trading?
In its early days, financial institutions and large banks were almost exclusively the only entities that could trade in the forex market. However, the market has become more retail-oriented in recent years and now caters to virtually all traders regardless of size.
Traders make money from forex trading by predicting the price movement of currency pairs and opening positions that stand to make a profit.
For instance, a trader opened a position in USD/AUD at a 1.50 exchange rate with a 100-lot volume. If he closed his trade at an exchange rate of USD/AUD 1.70, the trader would make a 20 USD profit from the exchange.
You can calculate how much you stand to gain or lose from each position when trading in forex using the following formula:
Profit/loss = (Closing Rate – Opening Rate) Volume Traded (1/Closing Rate)
Where:
Closing Rate = the exchange rate at which you close a position
Opening Rate = the exchange rate at which you open a position
Volume traded = the size of your position in lots or units
There are other factors that can affect your actual profit or losses when trading. These include spreads, commissions, and other additional charges related to trading. It is essential to take note of these factors to calculate your profits or losses more accurately.
In the next lesson, you’ll learn more about the currencies traded in forex and how they correlate.
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