Take a closer look at everything youll need to know about forex, including what it is, how you trade it and how leverage in forex works.
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Forex trading, also known as foreign exchange or FX trading, is the conversion of one currency into another. It is one of the most actively traded markets in the world, with individuals, companies and banks contributing to a daily average trading volume of $5 trillion.
While a lot of foreign exchange is done for practical purposes, the vast majority of currency conversion is undertaken by forex traders with the aim of earning a profit. The amount of currency converted every day can make price movements of some currencies extremely volatile. It is this volatility that can make FX so attractive to forex traders: bringing about a greater chance of high profits, while also increasing the risk.
There are two popular ways to trade forex markets; with derivative products and via a forex broker.
Derivative products track an underlying currency market, so that traders can speculate on whether the price will rise or fall. The most popular forex derivatives are spread bets and CFDs.
A forexspread betenables you to speculate on the future price direction of a currency pair. Your profit or loss is dictated by how far the market moves in your favour before you close your position and how much money you have put up per point of movement.
Abenefit of spread bettingis that its completely tax free.1
A forexCFDis an agreement to exchange the difference in price of a forex pair from when you open your position to when you close it. If the market price moves in your chosen direction, you would profit, and if it moves against you, you would make a loss.
Any CFD losses can be used to offset capital gains elsewhere.1
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A forex broker is a firm that buys and sells currencies on behalf of retail traders, usually via a forex trading platform. Like stockbrokers, they charge a fee though usually in the form of a spread instead of commission in order to execute orders placed by their clients. However, a key difference is that forex brokers will place tradesover-the-counterinstead of on an exchange.
Traditionally, a lot of forex transactions have been made via a forex broker, but with the rise of online trading you can take advantage of forex price movements using derivatives likespread bettingorCFD trading.
Regardless of whether you decide to trade via a broker or with derivative products, it is important to have an understanding of how the underlying forex market works.
Unlike shares or commodities, forex trading does not take place on exchanges but directly between two parties, in an over-the-counter (OTC) market. The forex market is run by a global network of banks, spread across four major forex trading centres in different time zones: London, New York, Sydney and Tokyo. Because there is no central location, you can trade forex 24 hours a day.
There are three different types of forex market:
: the physical exchange of a currency pair, which takes place at the exact point the trade is settled ie on the spot or within a short period of time
: a contract is agreed to buy or sell a set amount of a currency at a specified price, to be settled at a set date in the future or within a range of future dates
: a contract is agreed to buy or sell a set amount of a given currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding
Most traders speculating on forex prices will not plan to take delivery of the currency itself; instead they make exchange rate predictions to take advantage of price movements in the market.
A base currency is the first currency listed in a forex pair, while the second currency is called the quote currency. Forex trading always involves selling one currency in order to buy another, which is why it is quoted in pairs the price of a forex pair is how much one unit of the base currency is worth in the quote currency.
Each currency in the pair is listed as a three-letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself. For example,GBP/USDis a currency pair that involves buying the Great British pound and selling the US dollar.
To keep things ordered, most providers split pairs into the following categories:
Seven currencies that make up 80% of global forex trading. Includes EUR/USD, USD/JPY, GBP/USD and USD/CHF
Less frequently traded, these often feature major currencies against each other instead of the US dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
A major currency against one from a small or emerging economy. Includes: USD/PLN, GBP/MXN, EUR/CZK
. Pairs classified by region such as Scandinavia or Australasia. Includes: EUR/NOK, AUD/NZD, AUD/SGD
The forex market is made up of currencies from all over the world, which can make exchange rate predictions difficult as there are many factors that could contribute to price movements. However, like most financial markets, forex is primarily driven by the forces of supply and demand, and it is important to gain an understanding of the influences that drives price fluctuations here.
Supply is controlled by central banks, who can announce measures that will have a significant effect on their currencys price. Quantitative easing, for instance, involves injecting more money into an economy, and can cause its currencys price to drop.
Commercial banks and other investors tend to want to put their capital into economies that have a strong outlook. So, if a positive piece of news hits the markets about a certain region, it will encourage investment and increase demand for that regions currency.
Unless there is a parallel increase in supply for the currency, the disparity between supply and demand will cause its price to increase. Similarly, a piece of negative news can cause investment to decrease and lower a currencys price. This is why currencies tend to reflect the reported economic health of the region they represent.
Market sentiment, which is often in reaction to the news, can also play a major role in driving currency prices. If traders believe that a currency is headed in a certain direction, they will trade accordingly and may convince others to follow suit, increasing or decreasing demand.
Forex trading works like any other exchange where you are buying one asset using a currency. In the case of forex, the market price tells a trader how much of one currency is required to purchase another. For example, the GBP/USD currency exchange rate shows how many US dollars buy one pound.
When you speculate on forex price movements with CFDs or spread bets, you will be trading on leverage, which enables you to open a position for a just a fraction of the full value of the trade. Unlike non-leveraged products, you dont take ownership of the asset, but take a position on whether you think the market will rise or fall in value.
Although leveraged products can magnify your profits, they can also magnify losses if the market moves against you.
The spread is the difference between the buy and sell prices quoted for a forex pair. Like many financial markets, when you open a forex position youll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price slightly below the market price.
Currencies are traded in lots batches of currency used to standardise forex trades. As forex tends to move in small amounts, lots tend to be very large: a standard lot is 100,000 units of the base currency. So, because individual traders wont necessarily have 100,000 pounds (or whichever currency theyre trading) to place on every trade, almost all forex trading is leveraged.
Leverage is the means of gaining exposure to large amounts of currency without having to pay the full value of your trade upfront. Instead, you put down a small deposit, known asmargin. When you close a leveraged position, your profit or loss is based on the full size of the trade.
While that does magnify your profits, it also brings the risk of amplified losses including losses that can exceed your margin . Leveraged trading therefore makes it extremely important to learn how to manage your risk.
Margin is a key part of leveraged trading. It is the term used to describe the initial deposit you put up to open and maintain a leveraged position. When you are trading forex with margin, remember that your margin requirement will change depending on your broker, and how large your trade size is.
Margin is usually expressed as a percentage of the full position. So, a trade onEUR/GBP, for instance, might only require 3.33% of the total value of the position to be paid in order for it to be opened. So instead of depositing 100,000, youd only need to deposit 3300.
Pipsare the units used to measure movement in a forex pair. A forex pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35371, then it has moved a single pip. The decimal places shown after the pip are called fractional pips, or sometimes pipettes.
The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip. So, if EUR/JPY moves from 106.452 to 106.462, again it has moved a single pip.
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Despite the enormous size of the forex market, there is very little regulation because there is no governing body to police it 24/7. Instead, there are several national trading bodies around the world who supervise domestic forex trading, as well as other markets, to ensure that all forex providers adhere to certain standards. For example, in the UK the regulatory body is the Financial Conduct Authority (FCA).
How much money is traded on the forex market daily?
Approximately $5 trillion worth of forex transactions take place daily, which is an average of $220 billion per hour. The market is largely made up of institutions, corporations, governments and currency speculators speculation makes up roughly 90% of trading volume and a large majority of this is concentrated on the US dollar, euro and yen.
Gaps are points in a market when there is a sharp movement up or down with little or no trading in between, resulting in a gap in the normal price pattern. Gaps do occur in the forex market, but they are significantly less common than in other markets because it is traded 24 hours a day, five days a week.
However, gapping can occur when economic data is released that comes as a surprise to markets, or when trading resumes after the weekend or a holiday. Although the forex market is closed to speculative trading over the weekend, the market is still open to central banks and related organisations. So, it is possible that the opening price on a Sunday evening will be different from the closing price on the previous Friday night resulting in a gap.
The tax on forex positions does depend on which financial product you are using to trade the markets.
When you trade via a forex broker or through CFDs, any gains to your forex positions are taxable. However, your losses are tax-deductible, and depending on your circumstances can also be used to offset gains made elsewhere.
Alternatively, spread bets are a tax-free way to speculate on the forex market.1
Find out more about forex trading and test yourself with IG Academys range of online courses.
Take a look at our list of financial terms that can help you understand trading and the markets
Be aware of the risks associated with forex trading and understand how IG supports you in managing them
Discover the different platforms that you can trade forex with IG
1Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.68% of retail investor accounts lose money when trading spread bets and CFDs with this provider.You should consider whether you understand how spread bets and CFDs work, and whether you can afford to take the high risk of losing your money. Professional clients can lose more than they deposit. All trading involves risk.
The value of shares, ETFs and ETCs bought through a share dealing account, a stocks and shares ISA or a SIPP can fall as well as rise, which could mean getting back less than you originally put in. Past performance is no guarantee of future results.
CFD, share dealing and stocks and shares ISA accounts provided by IG Markets Ltd, spread betting provided by IG Index Ltd. IG is a trading name of IG Markets Ltd (a company registered in England and Wales under number 04008957) and IG Index Ltd (a company registered in England and Wales under number 01190902). Registered address at Cannon Bridge House, 25 Dowgate Hill, London EC4R 2YA. Both IG Markets Ltd (Register number 195355) and IG Index Ltd (Register number 114059) are authorised and regulated by the Financial Conduct Authority.
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Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.68% of retail investor accounts lose money when trading spread bets and CFDs with this provider.You should consider whether you understand how spread bets and CFDs work, and whether you can afford to take the high risk of losing your money.Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.