What is forex?
Forex is an abbreviation of foreign exchange, which uses exchange rates to work out the value of one currency against another.
For example, an exchange rate of 1.34 to convert pounds to US dollars means you get $1.34 for every pound. This shows that the pound is worth more than the US dollar.
What is forex trading?
Forex trading works by pairing two currencies together, and you predict if one currency will be worth more than the other by the end of a trade.
The first currency in a pair is the base currency, and the second currency is the counter currency, here are some examples:
|Currency pair||Base currency||Counter currency|
|GBP/USD||British pound||US dollar|
How to trade in forex
You get two options when forex trading, buy or sell. Here is how they could make you a profit:
If you buy, you need the value of the base currency to be worth more next to the counter currency, compared to when you started your trade.
If you sell, you need the value of the counter currency to be worth more next to the base currency, compared to when you started your trade.
For example, if the exchange rate for the EUR/USD was 1.1231, and you buy, you need the exchange rate to go up so that you can get more US dollars for every euro.
When you trade in forex there are two exchange rates; the bid (buy) and the ask (sell) exchange rate. The difference between the two is the spread.
The spread is measured in pips, using the fourth decimal point in a currency's rate.
The only exception to this rule is when the Japanese yen (JPY) is the counter currency in a pair, then you take second decimal point instead.
Here are some examples of different spreads used for the EUR/USD currency pair:
|Bid exchange rate||Ask exchange rate||Spread|
The number of pips shows how much a currency has to move before you can break even or start making a profit. This makes finding the smallest spread important when trading.
A pipette is the decimal point after a pip, for example:
If the US dollar had an exchange rate of 1.12368 against the euro, the pip would be the fourth decimal point (the 6), and the pipette the fifth decimal point (the 8).
Types of currency pairs
There are two types of currency pair you can trade on:
Major: Any pair that includes the US dollar (USD), as these are the most common trades in the world. The size of the spread in major pairs is often small.
Minor: Pairs that fluctuate in value more than major pairs, like the Australian dollar and the New Zealand dollar (AUD/NZD). The size of these spreads is often bigger.
How forex trading works
Forex trading is a leveraged investment, which means you only need to put down a small percentage of the value of the trade you are making.
For example, if a broker offers leverage of 100:1, you could open a trade worth £100,000 with only £1,000 in your account. This amount is known as the margin.
The margin acts as a deposit to cover any possible losses on your trades. You will also not be able to make trades that need a margin amount higher than the money in your account.
It is possible, but most brokers do not let you make trades unless you can afford the cost of the margin, which helps cover any losses.
Some brokers use a margin call, which means they contact you when your trade losses are close to maximising your account balance.
You get the option of adding more money into your account to keep your trades active, or your trades are all closed to reduce any further losses.
Forex spot trade
When you make a forex trade you do not need to have a foreign currency account, instead a broker converts your pounds into whichever base currency you trade with.
If you make a profit in a forex trade, the broker will convert any foreign currency back into pounds and into your account.
If you want to make a trade, a broker will require you to do this in a type of lot, which means you trade in increments of either 1,000, 10,000 or 100,000 units*.
Alternatively, you can trade forex through contracts for difference (CFDs) or spread betting. Find out how they differ to forex spot trading by reading the following guides:
A lot describes the size of a trade you make in forex, such as:
A standard lot: Equal to 100,000 units
A mini lot: Equal to 10,000 units
A micro lot: Equal to 1,000 units
You can only trade in round figures, so if a broker offered increments in 1,000s, you cannot trade using a decimal point, such as 1.5.
Forex spot trade example
Here is an example of how a forex trade works:
The sell/buy exchange rates are 0.75443/0.75453 (1 pip spread) for the Australian dollar and US dollar (AUD/USD) currency pair
You want to buy one standard lot, which is equal to 100,000 units of the base currency
This trade would be worth $75,453 (0.75453 x 100,000)
You open the trade with a 1% margin, equal to $754.53 ($75,543 x 1%)
You decide to sell when the counter currency's exchange rate reaches 0.75493
Multiply 0.75493 by your lot size of 100,000 to give you $75,493
Subtract this from your opening lot value ($75,493 - $75,453) to give you a profit of $40
The margin and any profit is converted into pound sterling. This means the margin would be £578.29, and the profit £30.66, based on an exchange rate of 1.30476.
Start forex trading
When you are ready to start trading in forex, you have to find a broker that lets you trade on the market you want.
Here is where to find more information on how to start trading and how to find the best forex broker.