What is forex (FX) trading?

FX trading, also known as foreign exchange trading or forex trading is the exchange of different currencies on a decentralised global market. It's one of the largest and most liquid financial markets in the world. Forex trading involves the simultaneous buying and selling of the world's currencies on this market.

Foreign exchange rates between different currency pairs show the rates at which one currency will be exchanged for another. ​It plays a vital role in foreign trade and business as products or services bought in a foreign country must be paid for using that country's currency.

a selection of currencies from the forex market

The foreign exchange market

The foreign exchange is one of the most widely traded markets in the world, with a total daily average turnover reported to exceed $5 trillion a day. The forex market is not based in a central location or exchange, and is open 24 hours a day from Sunday night through to Friday night. A wide range of currencies are constantly being exchanged as individuals, companies and organisations conduct global business and attempt to take advantage of rate fluctuations.

The foreign exchange market is used primarily by central banks, retail banks, corporations and retail traders. Understanding how each of these players interact with the FX market can help to determine market trends as part of your fundamental analysis. 

  • Central banks are responsible for managing their nation’s currency, money supply and interest rates. When action is taken by central banks, it is usually to stabilise the nation’s currency.
  • Retail banks trade large volumes of currency on the interbank market. Banks exchange currencies between each other on behalf of large organisations, and also on behalf of their accounts.
  • Corporations that have dealt with companies overseas have to take part in the foreign exchange market to transfer funds for imports, exports or services.
  • Retail traders account for a much lower volume of forex transactions in comparison to banks and organisations. Using both technical analysis and fundamental analysis, retail traders aim to profit from forex market fluctuations.

What is forex trading?

Foreign exchange trading is also known as FX trading or forex trading. It provides the opportunity to speculate on price fluctuations within the FX market. The goal of FX trading is to forecast if one currency’s value will strengthen or weaken relative to another currency. A forex trader will encounter several trading opportunities each day, due to daily news releases.

FX traders take advantage of this by becoming extremely receptive to market news releases and then trade based upon the suspected market sentiment. FX is an industry term that is abbreviated from forex, and is commonly used instead of forex. However, forex is also an abbrieviation of foreign exchange.

How does forex trading work?

Forex is always traded in currency pairs – for example, AUD/USD (Australian dollar v US dollar). You speculate on whether the price of one country's currency will rise or fall against the currency of another country, and take a position accordingly. Looking at the AUD/USD currency pair, the first currency (AUD) is called the 'base currency' and the second currency (USD) is known as the 'counter currency'. 

When trading forex, you speculate on whether the price of the base currency will rise or fall against the counter currency. So in AUD/USD if you think AUD will rise against USD, you go long (buy) the currency pair. Alternatively, if you think AUD will fall against USD (or that USD will rise against AUD), you go short (sell) the currency pair.

If you were right (that is if you went long AUD/USD and AUD went up in value against USD), you would make a profit. If the trade went against you, however, you would make a loss. 

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What is leverage in forex trading?

When trading forex, leverage allows traders to control a larger exposure with less of their own funds. The difference between the total trade value and the trader’s margin requirement is usually ‘borrowed’ from the forex broker. Traders can usually get more leverage on forex than other financial instruments, meaning they can control a larger sum of money with a smaller deposit.

Since forex is traded on margin, you only have to deposit a percentage of the full amount you wish to trade. Our margins start from 0.20%, which could be referred to as 500:1 leverage, as the value of the full position would be 500 times the value of the deposit required to open the trade. When trading on margin it's important to remember that your profits or losses are based on the full value of the position, not just the percentage you deposited, so you can lose more than your initial deposit. 

What is spread in forex?

The spread in forex trading is the difference between the buy and sell price of an FX currency pair. When you trade forex pairs, you are presented with a ‘buy’ price that is often above the market price and a ‘sell’ price that is often below the market price. The difference between these two prices is referred to as the ‘bid-ask’, or ‘buy-sell’ spread.

How to trade the FX market

There are a many ways to trade on the forex market, all of which follow the previously mentioned principle of simultaneously buying and selling currencies. If you believe an FX ‘base currency’ will rise relative to the price of the ‘counter currency’, you may wish to ‘go long’ (buy) that currency pair. If you believe the opposite will happen and the market will fall, you may wish to ‘go short’ (sell) the currency pair. To help you understand how forex trading works, you may find it useful to view some of our forex CFD examples.

The forex market was historically traded via a forex broker. However, with the rise of online trading companies, you can take a position on forex price movements with an MT4 or our proprietory Next Generation CFD trading account. Both the MT4 and Next Generation CFD trading accounts provide a form of derivative FX trading where you do not own the underlying asset, but rather speculate on its price movements. Derivative trading can provide opportunities to trade forex with leverage.

Forex trading strategies

Forex traders use FX trading strategies to guide their buying and selling activities. The ability to follow a strategy that informs a trader’s decisions is what differentiates trading from guesswork. Many traders create strategies by adopting elements from others’ trading strategies, but tailor the systems to meet their own specific needs.

A currency trading strategy often includes a number of forex signals and technical indicators. A forex trading signal can provide prompts to help determine entry and exit points for a given forex market. These signals can be determined by either manual or automated methods. Manual methods involve looking at chart patterns and averages to determine buy and sell opportunities. Automated methods use algorithms that determine trading signals and execute trades based on several pre-set conditions.

You can use numerous trading strategies to inform your trading decisions. Forex trading strategies, like other trading strategies, can be based on a combination of technical analysis and fundamental analysis. Technical and fundamental analysis are very different, so a blend of the two can be used to develop a more balanced trading strategy.

Many popular forex trading strategies, such as those outlined in our forex trading strategies guide, are based on chart patterns and mathematical formulas. Bear in mind that our forex strategies guide is not a definitive list, and just outlines some popular technical methods some experienced traders use. Other traders will trade based on macroeconomic forex news. This ‘big picture’ news tends to influence forex markets to a greater degree than any other factors. For example, news that suggests rising interest rates without a rise in inflation could increase the likelihood of a rise in currency value. By contrast, falling interest rates can increase the ease and likelihood of lending, but can devalue a nation’s currency in the long-term.

What influences the foreign exchange markets?

To trade the forex market with little awareness of the factors that influence the FX market can result in substantial losses. Many of the macroeconomic forces at play can have huge effects on the valuation of a currency.

When looking at forex markets, it's important to remember that a stronger currency makes a country's exports more expensive for other countries, while making imports cheaper. A weaker currency makes exports cheaper and imports more expensive, so foreign exchange rates play a significant part in determining the trading relationship between two countries. 

Political instability and economic performance

Political instability and poor economic performance can also influence the value of a currency. Politically stable countries with robust economic performance will usually be more appealing to foreign investors, so these countries draw investment away from countries characterised by more economic or political risk.

Furthermore, a country showing a sharp decline in economic performance could see a loss of confidence and investment, as capital moves to more economically steady countries. 

Interest rates

Interest rates, inflation rates and foreign currency rates are all interconnected, and as some rise others can fall. Central banks control the interest rate as a measure to control inflation. If a central bank wants to decrease inflation, it can increase interest rates in a bid to stop spending and lending. This generally increases the value of money in an economy, as there is less, or ‘more expensive’, money available in the economy. 

On the other hand, when there is more money with less value in an economy, businesses and consumers increase spending and lending through loans and other types of credit. Sellers will then increase prices, causing inflation and a lower-valued currency. These fluctuations in currency value are one of the reasons forex traders may look to trade on interest rate announcements from central banks, like the US Federal Reserve or the Bank of England.

Inflation rates

Often paired with interest rates, inflation rates can have a major influence on a nation’s foreign exchange rates. Rising inflation rates often have a negative effect on a currency’s value. Conversely, low inflation rates usually cause an appreciation in the value of a currency. When inflation is high, the price of goods and services increases, which can cause the currency to depreciate, as there is less spending.

Terms of trade

The terms of trade for a country represent the ratio of export prices relative to import prices. If a country’s export prices rise and its import prices fall, the terms of trade have favourably improved. This increases the nation’s revenue and is followed by an increase in demand for the country’s currency. This increase in demand can cause a rise in the currency’s value.

Debts

A nation’s debt can be a large influencer in the variations of its currency price. Countries with large debts in relation to their gross domestic product (GDP) will be less attractive to foreign investors. Without foreign investments, countries can struggle to build their foreign capital, leading to higher rates of inflation and thus, currency depreciation.

What are the benefits of forex trading?

Some of the main benefits of forex trading that make this asset class a popular choice among traders are:

  • The ability to trade on margin (using leverage)
  • High levels of liquidity mean spreads stay tight which keeps trading costs low
  • Prices react quickly to breaking news and economic announcements (this can be a disadvantage too)
  • Trade 24 hours a day from Sunday to Friday
  • The ability to go long and short
  • Wide range of markets (spread bet or trade CFDs on over 300 forex pairs with CMC Markets) 

Find out more about using leverage in forex trading.

What are the potential risks of forex trading?

Some of the possible risks involved in forex trading are:

  • You can lose all of your capital - leveraged forex trading means that both profits and losses are based on the full value of the position
  • Risk of account close out - market volatility and rapid changes in price can cause the balance of your account to change quickly, and if you do not have sufficient funds in your account to cover these situations, there is a risk that your positions will be automatically closed by the platform
  • Market volatility and gapping - financial markets may fluctuate rapidly and gapping is a risk that arises as a result of market volatility, and one of the effects of this may mean that stop-loss orders are executed at unfavourable prices​ 

Bottom line

Forex or currency trading is a fast-paced, exciting option and some traders will focus solely on trading this asset class. They may even choose to specialise in just a few select currency pairs, investing a lot of time in understanding the numerous economic and political factors that move those currencies.  

Still want to learn more about forex trading? Here are 5 common mistakes that forex traders make.

Disclaimer
Investing in CMC Markets derivative products carries significant risks and is not suitable for all investors. You could lose more than your deposits. You do not own, or have any interest in, the underlying assets. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading. Spreads may widen dependent on liquidity and market volatility. The information on this website is prepared without considering your objectives, financial situation or needs. Consequently, you should consider the information in light of your objectives, financial situation and needs. CMC Markets Asia Pacific Pty Ltd ABN 11 100 058 213, AFSL No. 238054 (the derivative product issuer), CMC Markets Stockbroking Limited, Participant of the ASX Group (Australian Securities Exchange) and SSX (Sydney Stock Exchange) and Chi-X (Chi-X Australia), ABN 69 081 002 851, AFSL No. 246381 (the stockbroking services provider) provides the financial products and/or services. It's important for you to consider the relevant Product Disclosure Statement ('PDS') and any other relevant CMC Markets Documents before you decide whether or not to acquire any of the financial products. Our Financial Services Guide contains details of our fees and charges. All of these documents are available at cmcmarkets.com.au or you can call us on 1300 303 888.
 
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