How Does the Forex Market Work?
In the forex market, you trade one currency for another. The two currencies being traded are known as a currency pair. Here are some examples:
- USDJPY - buy Japanese yen with US dollars
- JPYUSD - buy US dollars with Japanese yen
- USDCHF - buy Swiss francs with US dollars
- CHFUSD - buy US dollars with Swiss francs
The main currencies
The main currency used in forex is the US dollar; 40% of transactions involve the dollar. Other major currencies include the following:
- Japanese yen
- Swiss francs
- British pounds
- Canadian dollars
- Australian dollars
- New Zealand dollars
Although the US dollar still predominates, “cross rate” trading is increasing in Europe. This is where currencies are traded without using the dollar as an intermediary; for example, you can trade euros for British pounds or yen directly.
Types of transaction
There are five main types of forex transaction:
- Spot - 48% of the market
- Swaps - 39%
- Forwards - 7%
- Options - 5%
- Futures - 1%
Most traders work in spot forex. This is where currencies are exchanged directly. Here's an example:
- You want to trade US dollars and Swiss francs
- The instrument for buying Swiss francs with US dollars is USDCHF
- You buy when the rate is 0.7700 and get 770 Swiss francs for $1,000
- You wait until the Swiss franc goes up
- You sell at a rate of 0.7690
- Your profit is one Swiss franc or $1.32
- You only had to invest $10 because you had 1:100 margin
- You have made a 13.2% profit
In the example above, the price changed by 10 points – a point is 1/10,000th of a currency unit. Prices normally change by between 80 and 150 points per day, so you can make large profits. If the price above had changed by 80 points, you would have made $10.56 for a $10 investment.
However, the exchange rate can also move in the wrong direction, in which case you will lose money. That's why it's important to analyse the market before you buy, and to keep a close eye on your open positions. You can also set stops, which place a sell order automatically when a specific exchange rate is reached. That way, you can lock in your profits and limit your losses.
When you first start forex trading, we recommend that you open a Standard Mini Account with us. With a account, you can make trades for as little as two cents each. This is an excellent way to learn the forex market without taking significant risks.