What is Forex trading and how does it work?

What is Forex trading and how does it work?

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Forex trading is the process of buying one currency while selling another with the aim of making a profit from fluctuations in exchange rates. Using advanced online trading platforms, millions of traders across the globe participate in the largest economic market by turnover which in April 2025 surpassed US$9.6 trillion per day. Some of the key aspects that make Forex trading attractive include 24-hour accessibility, high liquidity, increased profit potential using leverage, and the ability to trade currencies using mobile apps and AI-powered trading tools.

Forex trading: The basics

You will come across the terms Forex, foreign exchange and FX which all refer to the foreign exchange market. Traders speculate on the price rise or fall of one currency against another. As a result, foreign exchange currencies are always displayed and traded in pairs such as the euro against the US dollar which appears as EUR/USD. The base currency is the first currency listed in the pair which is the currency being bought while the quote currency is the one being sold and appears on the right. The quote currency is often referred to as the secondary currency, counter currency or term currency and represents the amount required to buy one unit of the base currency. With short selling the opposite occurs with the base currency being sold and the quote currency being purchased.

Currency pairs

Currency pairs are divided into three main categories: major pairs, minor pairs and exotic pairs. Trading volume, liquidity and economic stability are among the factors that determine which group a currency pair falls in.

Major pairs

As inferred by their name, major currency pairs are the most actively traded currency combinations in the foreign exchange market. All major pairs involve the US dollar (USD) paired with another major currency. The 7 primary pairs are EUR/USD, GBP/USD, USD/JPY, USD/CAD, USD/CHF, AUD/USD and NZD/USD. According to BIS, these pairs represent approximately 75% of the Forex market turnover on any given day with the EUR/USD leading the way with more than 20% of the market share.

Minor pairs

Often referred to as cross-currency pairs or crosses, minor pairs do not include the USD dollar but contain any of the other major currencies, such as the British pound (GBP), euro (EUR), Australian dollar (AUD), Japanese yen (JPY), Chinese renminbi (CNY), Swiss franc (CHF) or Canadian dollar (CAD). Prominent minor pairs include EUR/GBP, EUR/JPY, and AUD/JPY.

Exotic pairs

Exotic pairs are made up of one of the major currencies and the currency of a developing/emerging economy. These economies are often characterised by rapid industrialisation, technological innovation, increasing global integration or a growing role in the supply of raw materials. Examples include the Indian rupee (INR) as India has one of the fastest-growing economies, the South African rand (ZAR) on the back of their mining industry and the Mexican peso (MXN) whose traded volume is contributed to its close ties with the US economy.

Forex trading: How does it work?

The foreign exchange market is both global and decentralised. It is an Over-the-Counter (OTC) market where trading takes place on a global electronic network. Forex trading platforms connect market participants (buyers and sellers) and provide real-time prices through a range of liquidity providers to facilitate trades. Commercial and investment banks, central banks, hedge funds, retail Forex brokers and retail traders are among the notable Forex market participants.

Bid-ask spread

Before you start trading it is essential to understand the bid-ask spread concept. The bid (sell) price appears on the left and the ask (buy) price appears on the right. In Forex, you buy at the ask price and sell at the bid price with the ability to open positions in both directions. The ask price is almost always higher than the bid price with the difference being the spread. Using the EUR/USD, this is how the spread is calculated:

Pips and lots

The spread is the transaction cost and is measured in pips. In this case the spread is 0.0004 or 4 pips. A pip (percentage in point) is the smallest price increment used in a currency pair and generally represents the fourth decimal place (0.0004). If the value of the EUR/USD moves from 1.1790 to 1.1798 it has increased 8 pips.

Forex trades are measured in lots. It is used to identify the number of currency units being bought or sold and is also utilised to express the size of the position. A standard lot is 100,000 units of the base currency, a mini-lot is 10,000 units and a micro-lot is 1,000 units.

Leverage

This is one of the most important features of Forex trading as it allows you to open larger positions with a small amount of capital which is called margin. Leverage is represented as a ratio such as 2:1 or 30:1 and will vary depending on numerous factors including the currency pair being traded. The following is an illustration of how leverage works:

• Leverage ratio (2:1): This means you control a position twice the size of your initial capital (margin). In this instance, you can open a total position size of US$2,000 by depositing an initial margin of US$1,000.
• Leverage ratio (30:1): Applying the same concept as above, a US$30,000 position size would have a margin requirement of US$1,000.

It is important to remember that there is a level of risk associated with leverage trading as it amplifies both profits and losses. A stop-loss order is an essential risk management tool that is used to limit risk exposure. It involves setting a price where the asset is automatically sold. This will help cap any losses if the market moves in the opposite direction to what was anticipated.

Trading sessions

With four primary overlapping trading sessions, the foreign exchange market operates 24 hours per day, 5 days per week from Monday to Friday. The primary sessions are:

• London (08:00 - 17:00 GMT)
• New York (13:00 - 22:00 GMT)
• Sydney (22:00 - 07:00 GMT)
• Tokyo (00:00 - 09:00 GMT)

The most active, liquid and volatile times occur when trading sessions overlap. The London/New York overlap (13:00 - 17:00 GMT) is regarded as the most volatile period as both major markets are open during this time.

Factors that influence Forex market

There are numerous factors that influence the foreign exchange market and cause Forex prices to fluctuate. Among the major drivers are economic factors, decisions made by central banks, geopolitical events and market sentiment.

Economic factors

Interest rates, inflation rates, employment data and GDP (Gross Domestic Product) growth are some of the key economic indicators that Forex traders monitor closely. Higher interest rates attract foreign capital which strengthens a currency while lower interest rates generally depreciate the value of a currency in the Forex market due to a reduced yield for investors.

Inflation works in the opposite direction with rising inflation often weakening a currency over the long term. However, in the short term, this often forces the hand of central banks who may raise interest rates which in turn can strengthen currency prices.

Positive employment data (high employment rate) often increases the demand of a currency on the back of economic health and the same applies to strong GDP growth which signifies a robust economy.

Consequently, decisions made by central banks relating to monetary policy can have a significant impact on the foreign exchange market and are heavily scrutinised by Forex traders.

Geopolitical events

Economic markets react to certain geopolitical events and the Forex market is no exception. Military conflicts and the threat of war, trade disputes and restrictions of trade by way of sanctions, political instability, global health crises such as pandemics and unforeseen natural disasters can all have a significant impact on the foreign exchange market. These events create uncertainty which can result in disruptions to trade and economic stability. Heightened levels of volatility often cause investors to withdraw from risky markets and shift to stable currencies and commodities. The USD, CHF and JPY are among the major currencies that typically strengthen during these events.

Market sentiment

The aforementioned factors create and shape market sentiment. They can significantly influence how investors perceive asset classes and financial markets including Forex. Positive (bullish) sentiment drives buying and currency appreciation. In contrast, fear, caution and scepticism lead to selling and currency depreciation. Forex trading platforms have tools that can assist with this including the Sentiment Trader which provides current and historic data on the percentage of traders holding long or short positions.

How to start trading Forex

A comprehensive understanding of how Forex trading works and the ability to recognise factors that influence currency prices are the foundations of a successful Forex trader. The next step is to develop a trading plan that defines the currency pairs that will be traded, the trading strategies that will be employed to identify trading opportunities, entry/exit points and a strict risk-management plan. Continuous learning is another necessity as it promotes long-term success but keeping up to date with shifting markets, new trading techniques and technologies along with emerging trends. If you want to explore the world of trading, open a trading account with FP Markets today.