How Does Forex Trading Work?

Forex, also known as foreign exchange, is the process of exchanging one currency for another. Trading forex always involves trading a currency pair, where one currency is sold and the other is bought. The value of a currency pair is determined by the relative value of each currency.

Each currency is designated by a three-letter code. The first two letters identify the country, and the third letter is the currency's initial. For example, the Japanese yen has the code "JPY" while the Great Britain pound has the code "GBP."

Forex pairs are generally categorized into four pairs:

Major Pairs - The most traded forex pairs that comprise approximately 80% of global trading.

Minor Pairs - Less traded currency pairs, usually consisting of major currencies against each other, excluding the USD.

Exotic Pairs - Consists of one major currency and one currency from an emerging economy. These pairs are less traded than majors or minors.

Regional Pairs - Comprising two currencies from the same region, such as Europe or Asia.

Transactions are typically executed by banks and other large financial institutions; however, retail investors can also participate in the market through online forex brokers. When trading forex, investors attempt to profit by buying and selling currencies by anticipating how currency pairs will change in value.

The foreign exchange market is the largest and most liquid financial market in the world, with a daily volume of over $5 trillion. The market is open 24 hours a day, 5 days a week, from 05:00 PM EST on Sunday until 04:00 PM EST on Friday. Trading takes place in major financial centers around the world, including London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, and Singapore. This gives investors the flexibility to trade at any time of day or night.

Forex prices can move quickly in response to news and data releases, making the forex market an exciting place for investors looking to make quick profits. However, the volatile nature of the market also means that investors can lose money if they don't carefully manage their risks and develop an effective trading strategy with an edge.

With investors having access to large amounts of leverage, the forex market can be risky for those without experience. However, with proper risk management and a foundational understanding of the factors that can influence the market, forex trading can offer opportunities for profit even in the most challenging market conditions.

Factors that Influence the Market

There are several factors that can affect currency values, such as inflation, interest rates, and political stability which can cause currencies to appreciate or depreciate relative to other currencies.

Inflation is defined as the rate at which the prices of goods and services increase over time. Central banks seek to control inflation by raising or lowering interest rates. When inflation is high, central banks will raise interest rates, making it more expensive to borrow money, to slow down the economy and reduce inflation. The reverse is true when inflation is low.

Interest rates are set by central banks and influence the cost of borrowing money. When interest rates are high, it becomes more expensive to borrow money, which can lead to a decrease in spending and investment, and cause currencies to depreciate. The reverse is true when interest rates are low.

Political stability is also a factor that can influence currency values. Currencies from countries with high levels of political instability tend to be less valuable than those from countries with low levels of political instability. This is because investors perceive more risk when investing in currencies from unstable countries and are therefore less likely to invest in them.

Market sentiment can also influence currency values. This is the overall mood of the market and can be influenced by factors such as economic data releases, political events, and natural disasters. When market sentiment is positive, investors are more likely to invest in riskier assets, such as currencies from emerging economies, which can cause those currencies to appreciate. Negative market sentiment can cause investors to sell off riskier assets and buy safe-haven assets such as the US dollar, which can cause currencies to depreciate.