An introduction to forex trading

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Also known as foreign exchange or currency trading, forex is one of the largest markets in the world.

In forex trading, traders hope to generate a profit by speculating on the value of one currency compared to another. This is why currencies are always traded in pairs - the value of one unit of currency doesn't change unless it's compared to another currency.

Currency pairs appear like this:

EUR/USD

The first currency listed is the base currency. The second currency is called the quote, or terms currency.

A sample quote would appear like this:

1.30380

The base currency is always worth one. The quoted price shows how much of the quote currency you'll get for one unit of the base currency. So in this case, 1 EUR is worth approximately 1.30 USD.

How do I trade?

Scenario 1: Buy trade

If you believe the current value of the euro is strengthening against the US dollar, you might enter a trade to buy euros in the hopes that the currency's value will become stronger compared to the US dollar. In this scenario, you think the euro is bullish (and the US dollar is bearish).

Scenario 2: Sell trade

Conversely, if you think the current value of the euro will weaken against the US dollar, you might enter a trade to sell euros in the hopes that the currency's value will become weaker compared to the US dollar. In this scenario, you think the euro is bearish (and the US dollar is bullish).

The buy or sell action you take always applies to the base currency. The opposite action automatically applies to the quote currency. So, if you buy the EUR/USD, this means you're buying euros and selling US dollars. If you sell the EUR/USD, you're selling euros and buying US dollars.

Trading the price difference

In the global economy, thousands of business transactions take place every day that require organisations to exchange the value of one currency for that of another.

When a United States manufacturer, say, buys Japanese steel, it needs to convert dollars to yen to pay the bill, while a British clothing retailer converts pounds to euros to pay for garments from a French textile company. In every exchange, prices need to be adjusted because one currency is typically weaker (has less value) while the other is stronger (has more value).

With so many changes taking place, currency values are rarely static. Throughout the course of the day, the value of one currency compared to another can change in response to political news, economics and interest rate changes. This means that a currency that was weaker than another in the morning may be stronger by the afternoon. These frequent changes in the value of currency are what drive forex trading and a trader's profit potential in the currency markets.

Forex trading is so popular that it makes up 95% of the foreign exchange transactions on the market. Conversion transactions only make up a mere 5% of the forex market, worth about an estimated $4 trillion a year.

A high volume helps traders execute trades that get them in and out of the market quickly. This ability to enter or exit trades with little hassle is called liquidity, and it can help provide you with more profit potential.

Around-the-clock trading

With shares, bonds and most other financial products that are traded on an exchange, you can only make trades during the exchange's business hours. Fortunately for forex traders, currencies are free of this restriction and can be traded day or night - 24 hours a day, five-and-a-half days a week.

At 12noon GMT on Sunday, financial markets open in the Pacific (Australia, New Zealand, Japan and various Asian countries). As those begin to close, markets in the Middle East and Europe start to open. When Europe is in mid-session, financial markets across the Americas open.

This pattern continues until 12midnight GMT on Friday when the American financial markets close for the weekend.

The consistent closing and opening of markets around the globe provides around-the-clock access to traders, five-and-a-half days a week. This is why you may hear many people refer to forex as a global market.

Who trades forex and what currencies can I trade?

You'll hear of everyone from big banks and hedge funds to small- and medium-sized traders talking forex. And since the markets are open longer than traditional markets, you can trade when it's convenient for you.

You can trade almost any currency - depending on which currency pairs your dealer offers. Interactive Trading has over 120 pairs to choose from. As a new trader, however, you will probably make your first trades with eight of the most commonly traded and exchanged currencies in the world.

Canadian dollar (CAD), United States dollar (USD), British pound (GBP), euro (EUR), Swiss franc (CHF), Japanese yen (JPY), Australian dollar (AUD), New Zealand dollar (NZD).

Currency codes are always three letters: the first two identify the country name and the last letter usually identifies the name of the currency. The exception to this rule is the euro (EUR).

Learn more about what you can trade with Interactive Investor, and open a free demo account to practise trading.