What is Forex?

What is Forex

AvaTrade is proud to bring you the most complete introductory guide to forex trading on the web. The forex market is the world’s most liquid market, with trading activity amounting to US$6.6 trillion per day (April 2021). At these levels, the forex market completely dominates global trading activity, dwarfing stocks, indices, commodities, or cryptocurrency trading by a long margin.

But what exactly is forex trading?

This comprehensive guide is designed to make it interesting for you to understand the intricacies of the currency trading market. We break it down into easy-to-read sections, for added convenience. You’re moments away from a world of trading opportunities – let’s get started!

Introduction to the Forex Market and How It Works

The Forex market goes by many different names, including the FX market, the currency market, or simply the foreign exchange market. It’s worth pointing out that the forex market is the oldest market in the world. When you buy and sell forex, you are exchanging the currency of one country with that of another country.

The Forex market operates everywhere, and anywhere. There is no fixed location since exchanges take place between parties in OTC transactions. This is known as the over-the-counter market. Since there are multiple forex market centres around the world, trading hours often overlap, allowing for 24/5 forex trades every week.

The Australian forex market is operational between the hours of 8 AM – 4 PM AEST (Australian Eastern Standard Time) for Sydney. The Frankfurt market centre opens at 4 PM Australia time, the London market opens at 5 PM Australia time, the New York market opens at 10 PM Australia time, and the Tokyo market opens at 9 AM Australia time.

Substantial trading volumes in each of these market centres contributes to the sheer size of the global forex market. Thanks to the participation of retail traders, speculators, investors, central banks and non-central banks, governments, and multinational corporations, Forex trading volumes are massive. In fact, this market is available to anyone who wants to exchange one currency for another.

Believe it or not, you have probably exchanged forex too! If you’ve visited New Zealand England, Wales, Ireland, Scotland, India, Thailand, the US, or Canada, you have traded forex. When you travel abroad, and exchange the Australian dollar for another currency, you’re participating in the forex market.

Ever seen those Bureaux De Change cubicles, or Currency Exchange offices in the city? That’s how forex exchange is done in person. You take one currency and exchange it for another currency at these forex offices. Nowadays, you can buy forex online through your bank via apps, or simply use debit cards denominated in the currency of the country you’re visiting.

Forex trading on the other hand, is done with an entirely different objective in mind – profiting from price fluctuations in currency pairs. Stay tuned, that’s coming up in the next section!

What Is Forex Trading All About?

In the simplest terms, Forex trading is the buying and selling of currencies. That’s it! While the world embellishes all the complexities involved in forex trading, it really boils down to buying one currency and selling another currency at the same time. Take the AUD/USD pair as a case in point. If you buy the pair, you are purchasing the base currency and selling the quote currency.

In this pair, the base currency is the Australian dollar, and the quote currency is the US dollar. When you buy the AUD/USD you are buying the Australian dollar and selling the US dollar. When you sell the AUD/USD, you are selling the Australian dollar and buying the US dollar.

Forex trading is an indispensable component of international trade and tourism, investment, banking, finance, global market stability, central bank forex reserves, et al. For our purposes as forex traders, the most important thing to look out for is the spread. That’s the difference between the purchase price and the sale price.

Factors Impacting the FX Market and Currency Exchange Rates

In economics, there are two things that determine the way the market moves. Supply and demand. A combination of macroeconomic variables and microeconomic elements combine to shape market activity. Of course, myriad other factors come into play as well. These include speculative sentiment, economic events, inflation, interest rates, and the like. The forex markets are bustling with activity, 24/5.

The financial markets, and all the trading activity taking place around-the-clock invariably impact the forex market, and vice versa. Many interrelated factors come into play, making it difficult to gauge cause and effect with forex trading. We can say with absolute certainty, that the forex markets are inextricably intertwined with the financial markets. Currency exchange rates are pivotal to global trade, commerce, finance, and economic stability.

If it all seems a little overwhelming, don’t fret! You don’t need to know all of these macroeconomic variables, macroeconomic factors, or understand the complex economic theories that make all of this possible. Break it down into its simplest components.

Start with a currency pair that you understand, such as the AUD/USD, AUD/GBP, or AUD/NZD. That’s your point of departure. Now, do a little research. What factors will impact supply and demand for these currencies? It’s a good idea to practice Forex trading with a demo trading account – at zero risk.

We encourage you to partner with AvaTrade Australia, a trusted broker with many years of experience in Forex trading. There is so much to learn about the currency markets, that it’s absolutely essential for you to stick with the best and forget the rest. We are here to help you trade forex and generate a favourable ROI on your FX trades. We will teach you everything you need to know about risk mitigation while trading Forex online.

Take a look at our comprehensive trading articles, videos, guides, FAQs, and other didactic teaching material. Our forex education is expressly designed for you, regardless of your experience level. Register for free, and enjoy unfettered access to our webinars, e-books, articles, and Forex trading guides. These educational resources have been compiled by forex experts, professional traders, and industry-leading aficionados.

You can take your Forex trading to the next level by engaging with forex experts to learn about potential trading opportunities. Put your practice to the test at AvaTrade Australia, and engage with fellow traders in real time. Our user-friendly platforms are designed to facilitate a seamless Forex trading experience. A literal world of trading opportunities is about to unfold before your eyes. Get ready to trade forex.

Top Reasons to Trade Forex

People trade forex for one reason – to generate a favourable return on investment. Put differently, people trade forex for gain. If you’re simply exchanging one currency for another, your motivations for forex exchange or different. You may be interested in buying foreign goods and services, or engaged in financial exchange. However, with forex trading, you are focused on buying and selling currency for speculative purposes. Ultimately, you’re trying to generate a favourable ROI when you trade forex.

Buying & Selling Goods and Services Abroad

The forex market is essential when buying and selling goods and services across borders. Whenever goods are imported into a country, forex transactions take place. Whenever goods are exported from a country, forex transactions take place. The home country and the foreign country each have their own currencies. Whenever goods and services move across borders, currencies are purchased and sold.

Believe it or not, buying & selling goods and services abroad comprises a small part of all forex exchange. Even though this market runs 24/5, it isn’t a major part of the forex market as we know it. You’re about to find out what makes up the lion’s share of forex trading.

Speculation in the Forex Market

Here’s the kicker! The majority of transactions taking place in currency markets,  90% +  are speculative in nature. They are geared towards generating an ROI a.k.a. profit. Investors, and traders – unlike travellers and tourists – have no interest in merely holding currency or exchanging currency. Speculators want to take advantage of market fluctuations in the forex market, by exploiting the spread between the bid price and the ask price.

The FX market provides plenty of opportunities for initiating multiple trades within a day – day trading. This is great for anyone with a short-term perspective on trading activity, particularly scalpers. There is a seemingly endless array of strategies available for forex traders, including short positions, and long positions.

It’s worth pointing out that forex trading is intuitively simple. This is what allows the currency market to enjoy massive liquidity, huge trading volume, and extreme volatility. Take note that there is more volatility in forex trading than in markets with lower trading volumes – now that’s something!

What is Forex? | AvaTrade Australia Video

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Quick intro to the FX market

AvaTrade Australia invites you to test your Forex trading skills online, in demo mode. If you don’t feel ready to trade forex for real money yet, try our zero-risk demo account, and practice forex trading at your leisure. You can do it in just 5 minutes!

Introduction to Currency Pairs

Recall that forex trading is all about selling one currency while buying another currency. The transactions take place at the same time. You’re exchanging one currency in the pair for the other currency in the pair. That’s how the term ‘currency pairs trading’ came to pass. As a case in point, let’s go back to the AUD/USD pair. If we are buying this pair, we are buying the Australian dollar (AUD), and selling the US dollar (USD).

The first currency in the pair is known as the base currency. The second currency in the pair is known as the quote currency. Another term for it is the counter currency. If the exchange rate of the AUD/USD pair is 0.78, that means that AU$1 is worth US$0.78. Clearly, the greenback is stronger relative to the Aussie dollar. When we buy the AUD/USD pair, we’re selling US dollars and buying Australian dollars. The prevailing exchange rate determines the amount we get for the forex transaction.

We strongly encourage you to read up as much as possible on exchange rates, and factors influencing relative strength or weakness in currency pairs. Now, we’re going to step it up a gear and introduce you to the market quotes with the AUD/USD, and any other currency pair. You will notice that there are 2 unique reference rates associated with each currency pair. With the AUD/USD pair, you might see something like 0.7778 – 0.7781. The figure on the left is known as the bid price. This is the price required to buy the forex pair. The figure on the right is known as the ask price. That’s required to sell the forex pair.

Take note that there is a difference of 0.0003.  In forex language, that’s the equivalent of 3 pips (percentage in point or price interest point). Pips are the smallest units of measurement when trading forex pairs. It typically refers to the 4th or 5th decimal place. Although it looks insignificant, pip-based price movements are incredibly important when leverage is used on forex trades. The greater the volume of trading activity, the more significant these pips become.

Now, there’s another concept in Forex trading that needs to be addressed – the lot. This is the smallest possible amount of currency that can be traded in an order. It represents 100,000 units of a specific currency. Most investors cannot afford to invest that amount of capital in a single order, however. Don’t stress! Reputable brokers like AvaTrade Australia provide a powerful trading resource to you, known as leverage. Think of leverage as a tool that helps you to perform a seemingly impossible task – like trading 100,000 units in a forex order.

Once again, we direct your attention at the AvaTrade educational resource centre for more information on leverage and what it can do for your trades. But we digress, let’s get back to currency pairs, specifically the ISO 4217 codes for major currencies. That’s coming up in our next section. Since there are so many combinations of currencies to consider, the global standard has defined a preset combination of FX pairs. Owing to popularity, trading volume, and viable combinations, we have major, minor, and exotic currency pairs. That’s in our next section!

ISO 4217 Codes of The Major Currencies

There are certain forex pairs that account for the majority of all forex exchanges in the currency market. In fact, as much as 80% of all forex transactions include major pairs. They are readily available and highly liquid. This makes them potentially lucrative currency pairs to trade. They also have low spreads compared to minor pairs, and exotic currency pairs. Avid traders routinely dabble in major currency pairs, since they represent the lion’s share of forex trading activity.

Take a look at commonly traded forex pairs and their names:

  • AUD/USD – Australian dollar/US dollar, known as the Aussie
  • NZD/USD – New Zealand dollar/US dollar, known as the Kiwi
  • USD/JPY – US dollar/Japanese yen, known as the Gopher
  • USD/CAD – US dollar/Canadian dollar, known as the Loonie
  • USD/CHF – US dollar/Swiss franc, known as the Swissie
  • GBP/USD – British pound/US dollar, known as the Cable
  • EUR/USD – Euro/US dollar, known as the Eurodollar

Minor Pairs

Minor currency pairs go by another name – currency crosses, or crosses. They aren’t as liquid as major currency pairs, but they are substantial in the currency trading arena. It is notable that these currency pairs do not include the US dollar as either the base currency, or the quote currency. However, minor currency pairs do include at least one of the major currencies such as the JPY, GBP, and EUR. Commonly traded minor currency pairs include the following:

  • CAD/JPY – Canadian dollar/Japanese yen
  • EUR/CHF – Euro/Swiss franc
  • GBP/JPY – British pound/Japanese yen
  • EUR/NZD – Euro/New Zealand dollar
  • GBP/AUD – British pound/Australian dollar
  • EUR/JPY – Euro/Japanese yen
  • CHF/JPY – Swiss franc/Japanese yen
  • NZD/JPY – New Zealand dollar/Japanese yen

Many novice FX traders tend to prefer minor currency pairs, since they are safer than the more volatile major pairs.

Exotic Currency Pairs

Major pairs include the US dollar as one of the currencies, minor pairs include major currencies with the exception of the US dollar, but exotic currencies have a certain appeal, despite their limited trading volume. Exotic pairs include a major currency, as well as a currency from a developing country such as Brazil, Russia, India, China, South Africa (BRICS), or other emerging market economies. These don’t have the same trading volume, or frequency as major pairs or minor pairs, but they are significant enough to warrant their own category.

  • AUD/MXN – Australian dollar/Mexican peso
  • NZD/SGD – New Zealand dollar/Singaporean dollar
  • JPY/NOK – Japanese/Norwegian Krone
  • GBP/ZAR – British pound/South African rand
  • USD/HKD – US dollar/Hong Kong dollar
  • EUR/TRY – Euro/Turkish lira

These pairs are interesting to trade, since they oftentimes have strong price movements. The markets that characterise these pairs are much smaller, since they are emerging market economies.

By now, you already understand the ISO 4217 codes of the currencies. Here’s a quick refresher before moving onto the next section:

  • DKK – Danish Krone
  • NZD – New Zealand dollar
  • MXN – Mexican peso
  • NOK – Norwegian Krone
  • ZAR – South African Rand
  • AUD – Australian dollar
  • CHF – Swiss franc
  • GBP – British pound
  • TRY – Turkish lira
  • USD – US dollar
  • EUR – Euro
  • CAD – Canadian dollar
  • ILS – Israeli shekel
  • INR – Indian rupee
  • KD – Kuwaiti dinar

Forex contracts

  • Currency Trading Contracts

    Most currencies are traded with contracts. The most popular option for speculators, day traders, and scalpers is spot contracts. This form of contract mimics the exchange of real money. It also presents as the smallest percentage of total Forex trading that takes place. The majority of FX trading is comprised of trading in financial derivatives. These include swaps, futures, and forward contracts. Let’s move on to different types of forex contracts.

  • Swap Contracts

    These types of forex contracts are usually drawn up by central banks, and are governed by inter-bank agreements. These are financial derivatives contracts between 2 transacting agents. Swaps  result in the swapping of revenue streams from assets held by each of the parties to the contract. There are hybrid swaps with exotic products, interest-rate swaps, and our favourite currency swaps.

  • Forward Contracts

    Forward contracts are settled at a date in the future, hence the name. The future date is known as the value date. At that specific point in time, the Forward Contract is null and void. Forward contracts are particularly useful in protecting against changes in exchanges rates in the future. They are also useful for setting forex prices now, for a future date.

  • Spot Contracts

    Spot contracts take place when both parties to a forex trade agree to buy & sell the currency at the prevailing price, known the spot price. This takes place at the same time as the settlement of the contract. Spot contracts are typically settled within 2 business days. They are the fastest option.

  • Futures Contracts

    Futures contracts are similar in many respects to forward contracts. However, forward contracts are executed by the counterparties to the forex trade. Futures contracts use clearing houses as guarantors for the forex transaction. These clearing houses intervene to form a legally binding contract between the parties. If a default occurs, the clearing house stipulations kick in. Futures contracts have superior liquidity to traditional forward contracts.

Using Leverage and Margin

Leverage and margin are powerful tools available to forex traders. Recall that the smallest possible forex position is 100,000 units of a currency. Since a lot is well beyond the trading capabilities of most people, it is necessary for brokers to offer tools allowing traders to trade these lots. Leverage is an option available to forex traders. This instrument allows you to apply a margin requirement to your trade, such as 1%, 2%, 3%, 4%, or 5% et cetera (depending on your broker, and to trade accordingly.

Consider what margin means in practical terms. If you are trading a position size of AU$100,000, and there is a 5% margin requirement, that means that you need 5% of that AU$100,000 trade value available in capital. That’s AU$5000. A 5% margin means that you have 1:20 leverage. In other words, you can trade 20 times your available capital. Leverage magnifies the trading power of your funds. The more you have, the bigger your trade size can be. The amount of leverage you have is dependent on the type of financial derivatives you’re trading, such as vanilla options, or contracts for difference (CFDs).

Be advised that leverage comes with pros and cons. Trades don’t always work in your favour, and that’s when leverage can work against you.

Purpose of Online Brokers

The interbank market is largely unavailable to retail traders, and the majority of day traders. For starters, the capital requirements for the interbank market are beyond the reach of most traders. Online brokers assume the role of intermediary, so that traders can access the markets 24 hours a day, 5 days a week. As one of the most reputable brokers, AvaTrade Australia works within legally-established frameworks to provide Forex trading services to clients. Whether you’re a retail trader or a professional trader, AvaTrade is geared towards your needs.

What does AvaTrade Australia provide to Forex Traders?

We’ve now introduced you to a smorgasbord of facts, features, and fundamentals of forex trading. It’s a complex arena peppered with challenges, opportunities, and wonderful learning experiences. To get the most out of your FX trading, you have to partner with a reputable broker. AvaTrade Australia is a trailblazing broker with years of experience in the industry. We encourage you to utilise our platforms, trading tools and resources, customer support and service, for trading Forex online.

Our forex offerings include the following:

  • Trade forex 24/5 at your convenience
  • Trade with complete confidence at our licensed and regulated broker
  • We offer competitive spreads from as low as 0.8 pips with no hidden fees
  • Enjoy manual trading, or automated trading courtesy of MetaTrader 5 (MT5) with us
  • Leverage is available so that you can magnify the trading capability of your capital
  • The forex market is the most capitalized and liquid market ($6.6 trillion per day) in the world
  • Trade dozens of currency pairs, including major pairs, minor pairs, and exotic currency pairs

FAQs about Forex

  • What exactly is the forex market?

    The Forex market, a.k.a. FX market, or currency exchange market is a global, decentralised exchange where traders, investors, speculators, banks, and businesses can buy and sell currency pairs. With Forex trading, one currency is bought and one currency is sold simultaneously. This takes place OTC (over-the-counter), directly between parties.

     
  • What are the components of a forex trade?

    Forex trades are made up of a base currency and a quote currency. The first currency in the pair is the base currency, and the other currency is the quote currency. When you buy forex, you buy the base currency and you sell the quote currency. When you sell forex, you sell the base currency, and you buy the quote currency.

     
  • Why should you trade forex?

    There are several reasons why individuals and businesses trade forex. One is to facilitate exchange across borders, for goods and services. Another reason is for speculative purposes. Traders buy and sell currency pairs with the intention of generating an ROI.