What's Forex? A Guide to Foreign Exchange

When people think of investing, the two words that come to mind are stocks and bonds. However, there's another market where people trade money itself: the foreign exchange market, or Forex for short. It's the biggest market in the world, with $6-7 trillion in volume every single day. That's more than both the stock and bond markets. It's also open 24 hours a day.

So what exactly is Forex?

Forex is simply the market in which currencies are traded. Think of it like trading stocks but instead of shares of a company, you trade dollars, euros, or yen. For example, if you think the value of the euro will exceed that of the dollar, you can “buy” euros with dollars. Later, if the euro does appreciate in value, you can sell it back for more dollars than you started with.

How are currencies traded?

Currencies are always traded in pairs. Some examples of these pairs are EUR/USD – euro vs. US dollar, USD/JPY – dollar vs. Japanese yen, and GBP/USD – British pound vs. dollar. The first currency is called the base and the second is called the quote. This fraction, also called the exchange rate or price, tells you how much of the quote currency you need to buy one unit of the base currency. For example, the exchange rate for EUR/USD is 1.16 at the time of writing this article. That means it costs 1.16 US dollars to buy one euro.

Now, let's say you think that in a month, the exchange rate will jump to 1.5, meaning that it will now cost 1.5 dollars to buy a euro. You could purchase 100 euros for $116. Let's say you're correct, and in a month, the exchange rate jumps to 1.5. At this point, you could trade your 100 euros that you bought for $116 for $150, about a 29% profit.

Pros of Forex

1. High Liquidity. Because the Forex market is so huge, you can enter your trades almost instantly.

   
   

2. 24-Hour Market. Unlike stock markets which only run from 9:30AM to 4:00PM, Forex trades around the clock because there’s always a market open somewhere in the world.

   
   

3. Leverage Opportunities. Forex brokers often let traders control much larger positions than their account balance, which can amplify gains (and losses too). This is because currency price changes are usually small compared to stocks or other assets, so leverage lets traders potentially make meaningful profits with less money. For example, a broker may allow you to buy $10,000 worth of a currency even though you only have $1,000 in your account.

Cons of Forex

1. Complexity. Currencies are influenced by many factors like interest rates, trade balances, central bank policies, and global crises. Some investors find this to be too much to monitor, and prefer to simply invest other assets.

2. Volatility and Leverage. Some currencies can fluctuate in value quicker than other assets, while leverage can also add additional risk when losses become extreme.

How People Trade Forex

There are three main ways: spot trading, which is buying and selling currencies at the current market price; buying futures and options, which are contracts to buy or sell currencies at a future date, often used for hedging risk; and buying currency ETFs, which are funds that track a currency or a basket of currencies. The last option makes forex more accessible to beginners.