Individual investors are increasingly trying their hand at foreign exchange trading, also known as forex or FX. No longer reserved for global corporations plus institutional traders, forex trading can diversify your portfolio, hedge against future weakening of the dollar, plus produce short- or long-term profits.
Read on to find out if forex should be part of your investment strategy in 2024. We’ll cover forex basics, including how currency trades work, what the risks are, plus how you can get started.
What Is Forex?
FX is currency exchange—that is, buying one currency with another. Foreign exchange is the largest plus most liquid financial market in the world.
If you’ve used an ATM machine internationally or purchased something from another country, you’ve participated in a currency exchange. The gist is that you use U.S. dollars to receive a different amount of another currency.
As you know, the mathematical translation of dollars to the other currency requires an exchange rate. Most exchange rates are floating, meaning they fluctuate up plus down. Those movements are driven by the supply plus demand in the global FX market. FX traders use those exchange rate shifts to realize gains or hedge against losses.
How Does Forex Work?
Forex trading is decentralized—currency trades transact across a global network of banks plus brokerages. This is different from public stock trading, which happens on an exchange like the New York Stock Exchange.
Currencies, like stocks, have identifying symbols or codes. The U.S. dollar is USD plus the euro is EUR. Other populer currencies include the British pound (GBP), the Canadian dollar (CAD), the New Zealand dollar (NZD), the Japanese yen (JPY) plus the Swiss franc (CHF). There are many more, but trading among these seven accounts for the majority of global FX activity.
Like many areas of finance, forex trading has its own lingo. Key terms to know include spot trading, currency pairs, lots, leverage plus pips.
Spot Trading
Spot trades are transactions in which the buyer immediately takes delivery of the asset. Currency spot trades use the current exchange rate (called the spot exchange rate) plus typically settle in two business days. This is the most straightforward model of currency trade.
Currency traders can also make forward or futures trades. In forward contracts, the buyer plus seller agree to an exchange at some future date, on negotiated terms. This is an over-the-counter instrument that’s typically non-transferable. Futures FX contracts, on the other hand, are standardized plus can be publicly traded.
Currency Pairs
Currencies trade in pairs, with a pair representing the exchange rate between the two components. EUR/USD, for example, references the relationship between the euro plus the U.S. dollar. The first currency in a pair—EUR in our example—is the base currency. The second currency is the quote currency.
Near the end of June, the EUR/USD exchange rate was around 1.09. This means that 1 unit of the base currency can buy 1.09 units of the quote currency. More specifically, €1 can buy $1.09.
Lots And Leverage
When you’re traveling, you can exchange money in small increments at any local bank or travel center. FX trades are not as flexible with respect to the transaction amount. Currencies trade in lots, mini lots or micro lots. These are 100,000, 10,000 plus 1,000 units of currency, respectively.
You don’t need €100,000 or even €1,000 for a single trade, however. This is because forex brokers typically allow for margin trading. So you can borrow funds from the broker to fund a portion of the transaction.
In the U.S., leverage on currency transactions is capped at 50:1 for major currencies plus 20:1 for less populer currencies. Said another way, you’d only need 2% or 5% of your own funding to make a trade. The exact percentage depends on the currency pair you’re buying plus your broker’s margin rules.
As with buying stocks on margin, you’re still on the hook for losses, even if they exceed the cash you put into the transaction.