What is Forex and how does it work?

Learn how to analyse the Forex market by reading all our articles dedicated to Forex before trading the major currencies.

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How to analyse and trade Forex?

The exchange rates of the main currency pairs

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The definition of the term Forex:

The term Forex is an abbreviation of its full name, ‘the Foreign Exchange Market’, the market for the exchange of foreign currencies. The Forex is therefore, as indicated by its name, an international market where currencies from all over the world are exchanged.

It is for example possible to exchange Euros against U.S. Dollars or against Yen or any other currency, common or exotic. But the Forex is also an investment market that enables traders to speculate on the exchange rate of one currency against another.


Operation of the Forex:

The basic operation of the Forex is fairly simple to understand. Its role is to determine the exchange rate of one currency against another, that means the value of one currency in other foreign currencies. To do so, the currencies are not quoted individually but in fact by pair, or ‘cross currencies’.

These pairs are expressed by abbreviations each representing a given currency. For example, the EUR/USD currency pair represents the Euro/Dollar rate, or the rate of exchange of the Euro expressed in U.S. Dollars. Therefore, if the currency pair EUR/USD is quoted as 1.25 this means that one Euro is equivalent to 1.25 U.S. Dollars. Note that the first currency in a pair is called the ‘base currency’ or ‘transaction currency’ and the second currency is called the ‘quote currency’ or ‘counter currency’.

The unit used to express this quotation is called a ‘pip’.

To calculate the exchange rate, the Forex completes a calculation based on the difference between the supply and demand. In fact, the stronger the demand for the purchase of a currency, the higher its exchange rate will be.


Quotation for currency pairs on the Forex:

We will look closer at the manner in which the currency rates are calculated. But first it is important to remember the actions that an investor can complete on the Forex.

When we complete an operation on the Forex we exchange one currency against another. But given that the Forex functions through currency pairs the possible actions are as follows:

  • Buying a currency pair represents exchanging a quoted currency against a base currency. Therefore, buying EUR/USD represents an exchange of U.S. Dollars for Euros.
  • Selling a currency pair therefore corresponds to an inverse movement, as this is exchanging a base currency for a quoted currency. Selling EUR/USD therefore means exchanging Euros against U.S. Dollars.

The calculation of the exchange rate on a currency pair therefore takes into account the exchange volume of a currency compared to another by using the system of supply and demand.


How to invest in Forex?

The Forex or foreign exchange market is one of the most popular markets for private investors for several reasons. First of all, it is the only market that is accessible 5 days a week and 24 hours a day. It is therefore possible to spend your free time and speculate in the evening or at the weekend.
In addition, it is an extremely volatile market and therefore offers interesting price differences on certain currency pairs.

To invest in the Forex market, you must first open a trading account with a regulated broker offering this type of service. Once this account has been funded with investment capital, you will have access to an online trading platform where you can take positions on rising or falling exchange rates.

Remember that Forex is always traded in currency pairs such as EUR/USD, which is the exchange rate of the euro to the US dollar. Thus, taking an upward position on this currency pair is like speculating that the euro will rise against the dollar. Here, the first currency in the pair, the euro, is referred to as the "base currency" and the second currency in the pair, the dollar, is referred to as the "counter currency".

Speculation in Forex always amounts to speculating on the evolution of the base currency against the counter currency. Using our example, if you expect the value of the euro to rise against the value of the dollar, you would take a buy position on this currency pair. If you expect the value of the euro to fall against the dollar, you would take a short position in the currency pair.

The gain or loss from this trade will be the difference in the price of the currency pair between the time the position is opened and closed, possibly increased by leverage.


Advantages and disadvantages of the Forex market

The foreign exchange market or Forex is a speculative market that offers some advantages but also some disadvantages. The main advantages of this market are the following:

  • The possibility of investing over extended time frames
  • High liquidity resulting in relatively tight fees or spreads
  • Prices that react strongly to announcements and economic news
  • The ability to take both buy and sell positions and thus speculate on price increases and decreases.

In addition to these few advantages, there are some disadvantages to the Forex market and investing in foreign exchange rates:

  • The risk of losing your entire capital, especially when using leverage which applies losses to the entire position.
  • The risk of account liquidation due to high market volatility and sometimes rapid price changes that can result in a zero or negative balance on your account if you do not have sufficient funds, leading to the closure of your positions.
  • Finally, as the volatility of the Forex market is one of the highest, the market can fluctuate rapidly and the spread will be impacted by this volatility. Stop loss orders can therefore be executed at unfavourable prices.

Before you start trading Forex, you need to make sure you understand the market and how it works.