Foreign exchange trading — also called forex trading or FX — is the buying and selling of currencies to make a profit. This type of trading is done on a global scale, and most of its participants are institutional investors like hedge funds, but individual investors can also trade forex.
In 2022, the forex market’s daily trading volume hit a record $7.5 trillion per day, according to the Bank for International Settlements (BIS), a financial institution owned by 63 central banks.
While forex trading can be lucrative, it also comes with risks that retail traders need to understand before getting started.
What is the forex market?
When you travel abroad, you may exchange some of your US dollars for the currency of the country you’re visiting. The forex market is based on a similar idea, but is implemented on a much larger scale. Forex traders across the globe speculate on how the value of certain currencies will change and exchange currencies based on those speculations.
For example, an investor who has euros but believes that the dollar is getting stronger may exchange their euros for dollars. Traders buy and sell currencies from all over the world, including Japanese yen, British pounds, Canadian dollars and Swiss francs.
Unlike the stock market, no central exchange oversees forex trading. There are also no physical buildings where these trades take place, like the New York Stock Exchange. All trades happen over the counter, electronically, via a network of global financial institutions. Because of that, the market is active overnight — it opens Monday morning in Asia (late afternoon in New York City) and closes Friday afternoon in New York.
CEIC data, last reported
Understanding forex pricing
Before you begin trading forex, it’s important to understand exactly what numbers and letters you’re looking at. When you trade on the stock market, you can identify different stocks based on their ticker symbols (Apple’s ticker, for example, is AAPL). When you trade forex, the currencies you’re exchanging have similar codes. You likely know the US dollar’s currency code, which is USD. But familiarize yourself with at least the major players in the forex markets, including:
- EUR: European Union euro
- GBP: British pound sterling
- JPY: Japanese yen
- CHF: Swiss franc
- CAD: Canadian dollar
- AUD: Australian dollar
Because the forex market is made up of trades that are exchanges of two currencies, exchange rates are displayed with both forms of currency. For example, EUR/USD would represent the exchange rate for the euro (the base currency) and the US dollar (the quote currency). In early April 2024, the price, or exchange rate, for that pair is 1.09, meaning that one euro costs $1.09.
If that figure rises, the value of the euro has risen relative to the value of the US dollar — and vice versa. Exchange rates fluctuate based on how high or low demand is for a certain currency, as well as how healthy a country’s economy is, interest rates, politics and more.
BIS data as of April 2022
The table above shows the most widely traded currencies by daily average turnover. In the forex markets, turnover is the total monetary amount of transactions executed within a specified time frame.
Uses of the forex markets
The forex market is complicated, and that’s partly because there are different ways to trade.
- Spot market: The first is via the spot market, which, like the name implies, is trading that happens on the spot. Trades on the spot market use the exchange rate at the exact time that the currencies are settled.
- Forward market: But many forex traders don’t execute their trades in real time. The forward market allows traders to lock in a currency trade at a specific exchange rate on a specific future date.
- Futures market: Forex futures are similar, but instead of the agreement being worked out privately between the two parties of the contract, the trades take place on an established exchange.
Pros and cons of trading forex
Like with the stock market, technology and digital trading platforms have made forex trading available not only to institutional investors but also to everyday investors with access to the internet.
One of the biggest benefits of forex trading is that it’s accessible, both because of those digital platforms and because of its low costs and the ability to trade around the clock. The fact that investors can trade for 24 hours straight during the weekdays also means that the market is highly liquid, so trades can take place without large deviations in prices.
Accessibility aside, forex trading can also be lucrative. Because the market experiences significant price swings, there are many opportunities to make money, especially for those who trade with leverage. Leverage involves using money borrowed from a broker to trade, magnifying potential wins.
But leverage also magnifies losses — and the risks associated with that make up one of the biggest downsides of forex trading. Forex trading with leverage can quickly result in losing a lot of money (even for experienced traders). As the Securities and Exchange Commission (SEC) puts it, “The only funds that you should put at risk when speculating in foreign currency are those funds that you can afford to lose entirely, and you should always be aware that certain strategies may result in your losing even more money than the amount of your initial investment.”
The SEC also points out that exchange rates are not always quoted the same way between market participants, transaction costs aren’t always clear and there are fraud concerns. When trading forex, you’re also up against the pros: Retail traders make up a very small amount of the overall forex market, and the lack of transparency makes it hard to compete with institutional investors.
Few, if any, retail investors have an edge in this area, said James Angel, an associate professor of finance at Georgetown University.
“It is unlike equities where a careful investor can uncover some good investment opportunities,” Angel said. “Forex trading appeals mostly to those who enjoy the gaming aspect of it.”
He doesn’t recommend it for most investors.
Are forex markets regulated?
The forex market is regulated on a country-to-country basis.
“Regulations vary from one jurisdiction to another, but they generally aim to protect investors, maintain market integrity and prevent financial crimes such as money laundering and fraud,” explained Richard Excell, a clinical assistant professor in the finance department at the University of Illinois’ Gies College of Business.
Central banks or treasury departments monitor market performance for disorderly movements and very occasionally intervene in the markets to smooth that out, Excell added.
In the US, the Commodities Future Trading Commission (CFTC) is primarily responsible for regulating forex.
How to start trading forex
Forex trading is not for everyone — in fact, it’s not for most investors. But if you have decided you would like to participate, here’s how to trade forex:
1. Do your research
Before you get started, fully understand the risks of forex trading and how pricing works. Excell said it’s also important to understand the fundamental drivers of foreign exchange: interest rate differentials, flows of capital, relative central bank policy and relative fiscal policy.
2. Choose a platform
Once you’re ready to start trading, you’ll need an account with a brokerage platform that allows forex trading. Many major investing platforms, like Vanguard and Betterment, don’t offer forex trading.
3. Pick an FX pair to trade
You’ll need to choose which currencies you plan to exchange. The most popular currency pairs as of 2022 included USD/EUR, USD/JPY and USD/GBP, according to the BIS.
4. Decide whether you want to buy or sell
After you’ve chosen the FX pair you want to trade, determine whether you think the base currency is going to grow or shrink in value relative to the quote currency. “Go long and ‘buy’ if you believe it will strengthen, or go short and ‘sell’ if you think it will weaken,” according to CMC Markets.
5. Stick to your strategy
When you begin trading, it can be difficult to keep track of your strategic, careful planning — especially if you make money and get excited to make more or lose money and feel pressure to earn it back. Make sure you’ve determined ahead of time how much you’re willing to risk and when you plan to enter and exit the market. Then, stick to your risk management plan.
Frequently asked questions (FAQs)
Because the prices of global currencies are in constant flux, prices in the forex market can change extremely quickly. However, the overall volatility of forex markets tends to be lower than that of the stock market, Excell said.
“Most forex currency pairs have an implied volatility right now in the 6-8% range, meaning an expected daily move is about 0.5%,” he added. “For stocks, the volatility is double that, in the 12-14% range for an expected daily move just under 1%.”
Forex trading can have higher return potential in the short term than stocks due to the constantly fluctuating currency prices and 24-hour market, but it also comes with more risk given the leverage that’s generally involved.
That’s why investors who implement a buy-and-hold strategy tend to gravitate towards the stock market and why forex traders buy and sell regularly.
