Forex (FX definition)

Are you familiar with FX, forex, and foreign exchange? These are different terms that refer to the same thing. It is the conversion of one currency to another country’s currency. In the case of the European Union, this applies to the entire Region. It is because the majority of the member-states adopted the Euro as their common currency since the year 1999.

But did you know people all over the world have a high interest in this topic? Whether it is FX, forex, or foreign exchange, Google trends data show that the search volume for these three is very high all year round. It is not surprising to hear this as the forex market is open 24-hours a day. And forex transactions happen anywhere in the world. But what makes forex very popular?

First, forex is the largest financial market on earth today. There are trillions of dollars worth of transactions happening every day. Imagine getting a small share of that pie. That will be big money for sure!

Do you know the answer to this question: what is 1% of $1 trillion? It is $10 billion! With this money, you can live the life of the rich and the famous. A lifestyle that we only read in tabloids and see in the movies. Second, forex is a financial market that is open to everyone. It does not matter if you work for the central bank or as a small-time retail trader.

You are allowed to participate in forex trading. You don’t have to graduate from a trading course at the University or get special education to start trading. In addition, the initial deposit required by some brokers can be as low as $5 to $100. This amount is affordable for many ordinary workers and professionals.

Third, there is so much hype in the forex industry about people getting rich overnight. Blame it on movies like “The Wolf of Wall Street” starring well-known actor Leonardo di Caprio. Or the documentary “Inside Job” narrated by another Hollywood actor, Matt Damon. Scammers also spread the news that forex trading is a get-rich-quick investment asset.

While it is true that some people do get rich from forex trading, many more traders lose their money. Only one out of three traders will gain profit while trading. The risks are real. Also, forex trading is not a form of gambling. To make consistent profits, you will need skill, discipline, and deep pockets.   

Forex is vital in our daily life, even if you are not yet involved in the forex trading market. Why? Because the world is interconnected. Goods and services are exchanged every day from one part of the earth to another. Countries enter into trade agreements where they agree to import and export products to one another. Of course, when you buy something from another place, you must pay using local money.

So, you need to convert your money to another currency, which is the definition of foreign exchange. The next time you eat a burger at your favorite fast-food restaurant or gas up at the petrol station, you are benefiting from international trading. If you have traveled abroad previously, you no doubt have made a forex transaction.

Go back to the time before the covid pandemic caused travel restrictions across borders. When you arrived at your destination, the first place you visited was one of the shops at the airport or downtown that offer to change your cash to the local currency. You did this because all businesses in that country do not accept foreign currency. When you take the bus, order food, or get a hotel, you need to pay with local currency notes. 

But forex is much more complicated than the physical exchange of currencies. A higher percentage of foreign exchange happens online. There are trillions of dollars being traded in forex every day without going to the bank or money exchange shop. In contrast to stock trading, where transactions happen on the stock exchange, forex is done virtually through over-the-counter or OTC transactions. An international network of banks manages the activities of the forex market.

Most transactions happen in four big cities: New York, London, Tokyo, and Sydney. Notice that these centers come from different parts of the globe, with different time zones. It is the reason why forex trading happens 24 hours a day. 

The end goal of all forex traders is to make a profit by buying and selling currencies. Traders sell their currency pair when the value is high, but they buy more of it when the value is low. And the good thing about forex trading is that you don’t have to buy and sell physical notes. Instead, you speculate whether the value of the currencies will go up or down. Yes, it takes two different currencies to tango in the world of forex trading.

The game plan is to trade when the exchange rate of one currency is high versus another currency. Let’s look at the USD/AUD currency pair as an example. When you take a position in the Australian dollar, you are at an advantage when the Australian dollar’s value goes up while the US dollar goes down.

In the same example, the US dollar (or USD) is called the base currency. While the Australian dollar (or AUD) is the quote currency. If the forex rate is 1.34, it means that you will need 1.34 Australian dollars (the quote currency) to buy one US dollar (base currency). Flipping the currency pair will give you AUD/USD. Taking the same example at 0.34, you will need 0.34 US dollars (the quote currency) to buy one Australian dollar (base currency).

Did you notice how the currencies appear? Yes, it uses three letters. It is the established naming convention in forex. The first two letters stand for the country or region name, and the last letter is the currency name. So, AU is from Australia (the country), and D is for the dollar (currency name). Other currencies include:

  • USD or US dollar
  • GBP or Great Britain pound
  • JPY or Japanese yen
  • CAD or Canadian dollar 

What are the types of currency pairs?

As we discussed, forex trading involves two currencies. In this process, one currency gets bought, and another currency gets sold. There are three types of currency pairings available today, depending on the volume of trades done. 

  1. Major currency pairs. It is the pairing of the top currencies used by traders. It represents 80% of the global forex trading volume and is the most liquid currency pair in the market today. There are seven currencies in this classification. All pairings here have the US dollar as one-half of the pairing. The others are the Euro, Japanese yen, British pound, Swiss franc, Australian dollar, and Canadian dollar. The major pairs are EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD, and USD/CAD. 
  2. Minor currency pairs. These are currency pairs that do not have a lot of trading activity. But they also involve the top currencies in the major currency pairing. The only difference is that the US dollar is missing. Instead, they get paired with each other. These pairs are not as liquid as the major currency pairs but have enough volume to execute trades if clients choose them. The minor pairings include EUR/GBP, GBP/JPY, and EUR/CHF.  
  3. Exotic currency pairs. It is the pairing of one major currency with a small or developing economy. Some traders avoid this pairing as it is hard to sell positions due to low liquidity. Also, the spreads are bigger. It affects the value of the money and the commissions charged by brokers. Some examples of this are USD/SGD (Singapore dollar), USD/ILS (Israel shekel), and GBP/THB (Thailand Baht).

Why does the value of currency change?

Many factors influence the value of currencies. The highest contributor is the supply and demand for that currency. The more people buying it means there is high demand. Its value increases when the demand is high and the supply is low. If people are selling it, yet there are only a few takers, the price goes down.

But supply and demand are not the only factors to consider. Currencies are also affected by external factors like central bank policies, economic indicators, political events, market sentiments, and health concerns like the covid pandemic. 

Policies implemented by the central banks have almost immediate effects on the foreign exchange rate. These policies include adjustments on interest rates, announcements on inflation levels, economic growth forecast, and quantitative easing. As for economic indicators, the CPI (or consumer price index), GDP (or gross domestic product), and interest rates are top on the list. Other factors to watch out for include unemployment rate, minimum wage, retail sales volume, and inflation rate.

Fortunately, this type of information is readily available in the US, countries of the European Union, and the rest of the free world. There is even a regular release date for these data. And the public has access to all this information.

Another factor to consider is political events and policies. Politics play a vital part in the economic, social, and cultural state of a country. In turn, this affects the value of the local currency. Events such as the US presidential elections and homeland security policies by former president Donald Trump have affected the value of the US dollar.

In Europe, the UK’s Brexit has negatively affected the Euro and the other currencies of the world. It includes the member-states of the European Union. In addition, environmental and health problems can shake the forex trading market. Natural disasters such as powerful typhoons and destructive earthquakes can stir the forex market. At the time of the disaster, economic activities are at a standstill.

Trading activities get suspended due to power and telecommunication breakdowns. Work areas and transportation systems are closed. And our experiences in fighting the covid pandemic show that health concerns have an economic and social impact. Policies such as frequent quarantine, lockdown of factories and industries, and limited supply of vaccines can bring the currency to its lowest point in history.

Lastly, we will look at the market sentiment. It is the consensus of most traders on the possible direction of the currency value. If they feel that the currency is about to take a downward turn, they sell it. And if they convince more and more traders to sell too, then the forex value will be affected. Professional traders and stakeholders (such as banks) can trigger the buying or selling of currencies based on speculation. If the increase or decrease gets followed by a sharp movement in the other direction, the trend is false.

How is forex trading different from stocks trading?

Both forex and stocks are investment options in the financial marketplace. They have the same goal of getting financial gains from trading. They use the same brokers, the same tools, and even the same trading strategies. They are also affected by the same market forces, such as economic indicators and news updates. But many factors differentiate one from the other. 

The first difference is the trading asset used. Forex uses currencies of different countries in trading, while stocks buy and sell shares of companies. Since there are only a few currencies today, the number of assets you can trade in forex is limited. Most brokers offer only 50 to 60 currency pairs and only seven classified as major currencies. These are highly liquid and stable. Stocks, on the other hand, number by the thousands per country.

If you multiply this by the number of countries worldwide, you will get thousands and thousands of stocks available for investors. Also, the stock market has a higher growth potential since new companies start every day. In contrast, countries remain the same, and the number of currencies does not change. 

The volume of trades happening every day is also very different. Forex is a runaway winner with trillions of dollars traded daily. It is the biggest trading market in the world. In contrast, stocks have much less volume per day. Another advantage of forex vs. stocks is that forex trading is not limited to one country or jurisdiction. Forex trading happens everywhere.

When you decide to sell your currency, another person from the opposite side of the globe may buy it. But in stocks trading, transactions are limited to only one country or jurisdiction. There are more regulations for the stock market since they operate from a central location called the stock exchange. It is a physical structure that houses brokers, traders, and assets. The exchanges are places where the actual trading activity happens. But, the forex marketplace has no central location.

There is no single body regulating its activities worldwide. Forex trading gets done online, controlled by a network of global banks.

Accessibility is another consideration. It is easier to be a beginner in forex trading than in the stock market. The initial deposit requirement to begin forex trading can be as low as $5. It is very accessible to retail traders, workers, and professionals from other industries. Some account types even have no deposit requirements, zero commissions, and no deposit and withdrawal fees.

Also, forex trading happens round-the-clock, 24-hours a day on weekdays. It can offer this much flexibility since trading is happening throughout the world. The stock exchanges, in contrast, operate only within office hours on weekdays.

The holding period of investments also differs between stocks and forex traders. Stocks are long-term investment assets. It means traders will hold on to the shares for many months, years, or decades. The reason is that the price of stocks can grow significantly and generate more profit in the long run. Forex traders, on the other hand, prefer to buy and sell currencies quickly. Most of them will close the transaction within the day. It is why they are called day traders. Scalpers will open and close trading in less than an hour to a few minutes, attempting to get small profits but many times each day.

Lastly, there is a greater chance to make higher profits in forex trading than in stocks. It is because of the higher leverage used in forex.

In the US, for example, the leverage level for forex is at 50:1, while for stocks, it is 2:1. So, forex traders in this country can buy and sell in different currency pairs up to $5,000 for every $100 deposit. Imagine how much more trading you can do with leverage of 1,000:1, offered in other areas.

But of course, the risks are also higher. With this much leverage, you can lose your money fast. It is why beginners in forex trading are better off starting with a conservative leverage level of 20:1 to 50:1.

Also, everyone interested in forex must take advantage of the free demo account offered by most brokers. It is the best way to practice trading without the risk of losing your money fast in the forex market.