The forex market: what is it and how does it work

What is forex trading?

Forex (FX) trading is the buying and selling of foreign currency pairs at a price agreed by both parties involved in a trade. These parties in the trade can either be individuals, companies or central banks. Commercial banks convert foreign currencies into local ones, while the central banks regulate the exchange rate.

Forex trading is done with the aim of earning profits from the currency conversions that come with the change in exchange rates, resulting in FX volatility. The higher the volatility of forex markets, the higher the risk and reward, something that’s likely to be attractive to you if you’re risk tolerant.

What are the five types of forex markets?

There are five types of forex markets that you need to consider. Below you’ll get an explanation of each type of forex market and how they work.

Spot forex market

The spot forex market enables you to buy foreign currency ‘on the spot’, meaning the exchange occurs in real-time as the trade is settled. When trading spot forex, you’ll be buying and selling the pair at the current market rate or spot price. With us, you’ll get increased access when trading the spot forex market.

Forex forwards market

A forex forwards market enables you to trade currency pairs at a set price on a predetermined date. With us, you’ll trade forex forwards using spread bets. Forex forwards aren’t standardised for all traders, and you can trade them OTC.

When trading the forward forex market, you’ll be speculating on the currency pairs without taking physical ownership of them. Forex forwards will enable you to take longer-term positions without overnight funding costs. Our forex forwards act in a similar way, but there are also underlying FX futures.

Forex futures market

Forex futures are contracts that enable you to open a long (‘buy’) or short (‘sell’) position on a currency at a set time, contract size and with a specified expiry date. You can use futures contracts to hedge against foreign exchange risk. Our forex forwards act in a similar way. With us, you can only trade forex forwards.

Forex options market

Forex options are derivative products that give you the right, but not the obligation to trade FX on a specified expiry date and set (strike) price. When buying, forex options will enable you to have limited risk without having the obligation to complete the purchase. On the other hand, you’re likely to be exposed to unlimited risk when selling.

The two types of options you’ll come across when trading forex are puts and calls. With us, you’ll have increased access to buy and sell forex options using the UK's No.1 trading platform and retail FX provider. ^2,3

Forex pairs are made up of a 'base' and a 'quote' currency. When looking at a currency pair, the base is the first one you see, and the quote is the second. For instance, for GBP/EUR the base currency is GBP while EUR is the quote.

Forex brokers vs banks: where do you trade forex?

Forex brokers and banks are two of the most common FX providers. Banks offer forex trading services for clients that request these services. Banks trade currencies interbank and will execute speculative forex trades on your behalf.

Forex brokers – both individuals and companies – facilitate the buying and selling of foreign currency when trading. An online broker acts as a ‘middleman’, enabling you to speculate on the price movement of forex pairs without taking ownership of the physical currencies. With us, you can trade forex using a spread betting and or CFD trading account.

Online brokers like us provide an intuitive web platform and mobile apps for you to execute your forex trades, while also giving you access to third-party platforms like MetaTrader 4 (MT4), ProRealTime and L2 Dealer.

When trading with us, you ‘ll have access to a specialised team that will give you help and support through our 24-hour helpdesk team available from Monday to Friday, and 9am to 5pm Saturday and Sunday.

What affects forex rates?

There are various factors that affect the forex rates. These include inflation, interest rates, economic performance, government debt, current account deficit, terms of trade and speculation.

1. Inflation: a currency’s value will depreciate when there’s an increase in inflation, resulting in the rising cost of goods and services. A significant decrease in inflation tends to increase the inflow of money into a country, increasing the local currency’s buying power and strengthening the forex rate
2. Interest rates: impact the cost of borrowing from the banks. Interest rate increases lend themselves to an appreciated local currency. The central bank will hike interest rates to slow inflation when economic growth is happening at a fast pace
3. Economic performance: political stability lends itself to more foreign direct investment coming into a country, leading to the appreciation of the local currency
4. Government debt: the central government’s high public debt, is likely to limit the flow of foreign direct investment into a country, leading to a rise in inflation. This may cause foreign investors to divest, resulting in an oversupply of the local currency and its subsequent depreciation
5. Current account deficit: when an imbalance in the value of goods and services occurs between a country and its trading partners, this affects the forex rate. Importing more goods and services compared to exports will lead to a trade balance deficit as more foreign capital will be needed for trading. This will result in a decreased demand of the local currency
6. Terms of trade: this is a country’s export to import price ratio. Terms of trade in a country are enhanced when export prices increase at a higher rate compared to the imports. This increases the country’s revenue, raising the local currency demand and value, resulting in an appreciated forex rate
7. Speculation: when local currency is expected to appreciate, investors are likely to increase their demand for it, further increasing its value. This will result in an increase in the forex rate

How to trade the forex market

1. Create an account or login into an existing account
2. Choose a FX pair and decide if you’ll trade it using spot, forwards or options
3. Decide whether to buy or sell
4. Set your position size and manage your risk
5. Open and monitor your position

Open an account and place your order

Create an account with us and open your position using spread bets or CFDs on our award-winning trading platform.² Place your order by choosing the forex pair you’d like to trade and the position size.

Choose a FX pair to trade and decide if you’ll trade it using spot, forwards or options

With us, you can trade over 80 currency pairs. These include major currencies like GBP/USD, EUR/USD (Euro/US dollar), USD/JPY (US dollar/Japanese yen), USD/CHF (US dollar/Swiss franc), AUD/USD (Australian dollar/US dollar). Exotic currencies you can trade include EUR/HUF (Euro/Hungarian forint). USD/TRY (US dollar/Turkish lira), USD/SEK (US dollar/Swedish krona), USD/ZAR (US dollar/South African rand).

Decide whether to buy or sell

You’ll buy the forex pair if you believe the value of the base currency will increase against the quote. Alternatively, you’ll sell if you expect the base to depreciate against the quote currency.

Open and monitor your position

Monitor your open forex trade using the ‘open positions’ section of our online trading platform. You’ll be able to set price alerts to receive emails and push notifications when your trade reaches a certain buy or sell percentage point.