Forex trading is the buying and selling of international currencies, where traders exchange one currency for another, and outcomes depend on exchange-rate movements. This educational guide explains the fundamentals of forex trading and the key concepts involved.
The foreign exchange market, often called the forex or the FX market, is the world’s largest financial market and attracts speculators looking to place trades based on how they expect respective currency prices to move.
Before diving into specific forex concepts, it’s essential to understand the broader market context in which currency trading occurs. From understanding currency pairs, to recognising the key factors that drive exchange rates in this 24-hour global marketplace.
Understanding the FX market
The FX market is the buying and selling of currencies to serve multiple purposes including international trade settlements, corporate hedging, central bank operations and for speculation purposes.
This massive market comprises both retail and institutional investors with average daily trading volumes exceeding $9.6 trillion.
Who Participates in FX Markets?
The foreign exchange market includes any person or organisation which buys or sells currencies. It is made up of a wide range of participants, from central banks to retail investors. Each type of trader has different objectives and trading volumes.
- Central banks participate to manage their currency reserves and implement monetary policy.
- Companies may buy raw materials in one currency and sell products and services in another.
- Investment banks facilitate large transactions for clients and trade for their own accounts.
- Retail traders, while representing a smaller portion of overall volume, access the market through brokers for speculative purposes.
What Moves Exchange Rates?
Currency price moves tend to be driven by the relative performance of a country’s economy. If a country performs well, its currency often strengthens and goes up in value as investors seek exposure to that growth.
Macroeconomic factors which reflect, or even trigger the macroeconomic growth include:
- Interest rates
- Inflation levels
- Economic performance
- National debt
- Political stability
Conversely, a negative perception of any of these factors, such as increased economic or political uncertainty can weaken a currency and encourage international investors to place their capital elsewhere.
[HIGHLIGHT] Exchange rates reflect the relative economic health between two countries, making forex a unique market where traders analyse paired economies rather than single assets. [END HIGHLIGHT]
How Forex Trading Works
Forex trading works by buying or selling a
This paired structure means that forex traders are essentially making a relative value judgement between two economies.
Currency Pairs Explained
Every forex trade involves a currency pair; the first currency listed in a currency pair is the base currency and the second is called the quote currency. For example, in EUR/USD, the euro is the base currency and the US dollar is the quote currency.
If the exchange rate on that currency pair is 1.10 then you can buy 1 euro for 1.10 US dollar. The table below outlines other key terms which are used in the forex market and expands on their meaning.
| Term | Plain-English Meaning | Why It Matters |
|---|---|---|
| Currency Pair | Two currencies traded together | Defines what you’re buying and selling |
| Base Currency | The first currency in a pair | The currency you’re taking a view on |
| Quote Currency | The second currency in a pair | What you’re measuring the base against |
| Exchange Rate | The price of one currency in another | Determines trade value |
| Pip | Smallest price movement (usually 0.0001) | Your trade execution cost |
| Spread | Difference between buy and sell prices | Your trade execution cost |
| Leverage | Borrowed capital for larger positions | Amplifies gains and losses |
| Margin | Deposit required for leveraged trades | Your actual investment |
Understanding Pips
Price moves in the forex markets are measured in ‘pips.’ A pip is the smallest move a currency can make. In a currency pair that is priced to four decimal places such as GBP/USD, a pip is a price movement of 0.0001.
- Most major currency pairs are quoted to four decimal places, making one pip equal to 0.0001
- Japanese yen pairs are an exception, quoted to two decimal places.
Tip: Forex markets are dynamic and you may not execute your trade at the stated price due to slippage.
The Role of Leverage and Margin
Leverage works by traders depositing
Leverage increases the size of both potential gains and losses. While it can amplify returns, it equally amplifies risk, making proper risk management essential.
Leverage Case Study: A trader with a $1,000 margin deposit who is applying leverage of 30:1 controls a $30,000 position. A 1% favourable move would result in a $300 gain (30% on the initial margin), but a 1% adverse move would create an equivalent loss.
Tip: It is crucial to appreciate leverage magnifies both opportunities and risks in equal measure.
Key Features of Forex Markets
Important and distinctive features of the forex markets include the hours which they are open and the scale of the activity in them. These factors can influence the risk and opportunities associated with each currency market.
Market Hours
You can trade forex on a 24/5 basis. The forex market operates continuously from Monday morning in Sydney through Friday evening in New York, following the sun across major financial centres.
Tip: The extended schedule of forex markets provides flexibility but also means that significant moves can occur at any time.
Liquidity
The size of the forex markets and the volume of trades booked each day typically makes it easier to trade in and out of positions compared to many other markets.
This high liquidity generally results in tighter
What Causes Price Changes in Forex Markets
Price changes in forex markets are driven by real-world events such as investors changing their view on the prospect of a particular country’s economy. Some of the most commonly seen FX price drivers are outlined in the table below.
| Driver | Examples | Why It Can Move Exchange Rates |
|---|---|---|
| Interest Rate Expectations | Central bank meetings, inflation data | Higher rates typically trigger inflows of capital which strengthen currencies |
| Inflation | Consumer/producer price indices | Affects purchasing power and central bank policy |
| Growth Data | GDP, employment figures | Strong growth typically supports currency value |
| Risk Sentiment | Market volatility, global events | Drives flows to/from safe-haven currencies |
| Geopolitics | Elections, trade relations | Creates uncertainty affecting currency stability |
| Central Bank Actions | Policy statements, interventions | Direct impact on money supply and rates |
Final thoughts
Forex trading represents a unique corner of the financial markets where currencies are traded in pairs, reflecting relative economic values between nations.
Understanding core concepts like currency pairs, pips, spreads, and leverage provides the foundation for developing a stronger understanding. Starting off by mastering the basics is important because of the market’s size, liquidity, and 24-hour nature, which creates both opportunities and risks that differ from other asset classes.
Visit the eToro Academy to explore the forex markets further.
Quiz
FAQs
- What are major vs minor vs exotic pairs?
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Major pairs include the world’s most traded currencies paired with USD (EUR/USD, GBP/USD, USD/JPY, USD/CHF). Minor pairs feature major currencies without USD (EUR/GBP, EUR/JPY). Exotic pairs include one major currency and one from a smaller or emerging economy, typically featuring wider spreads and higher price volatility.
- What does liquidity mean in forex?
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The size of the forex markets and the volume of trades booked each day makes it easier to trade in and out of positions compared to other markets. High liquidity means traders can generally enter and exit positions quickly with minimal price impact. Higher levels of liquidity are typically found in the markets of major currency pairs which is why many forex strategies are adapted to trade these markets..
- What is slippage and when can it occur?
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Slippage refers to the difference between the expected price of a trade and the actual execution price. It can occur during periods of high volatility, major news events, or when trading less liquid currency pairs. Market gaps over weekends can also result in slippage when positions are carried overnight.
- How can stop-loss instructions help when trading markets open 24/5?
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Stop-loss instructions automatically manage risk during overnight sessions or periods when a trader cannot monitor the screen. They are automated instructions built into your trading account to close all or part of a position should the price reach a particular level. Since 24/5 markets (such as Forex, commodities, and crypto) operate continuously, stop-loss orders provide a crucial safety net against sudden, high-volatility price moves or news events that occur outside of standard exchange hours.
- How much leverage can I use when trading forex?
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You can find brokers offering maximum leverage limits in the region of 1:30 on forex trades. Forex price moves are often less extreme compared to other instruments, but there are still plenty of risks involved with leverage trading that should be considered before opening a trade.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research.
Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. The availability of all the above-mentioned products and services may vary by jurisdiction and country.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.