Forex trading explained

Most investors only deal in currencies when they’re about to go on holiday. But they could be missing a chance to profit from the most liquid market around – the currency market.

What is the forex market?

The foreign exchange (forex, or FX) market is by far the world’s biggest. Daily turnover is about ten times that of global equity markets – and very liquid, so deals of all sizes and in virtually all currencies can be done quickly and easily.

Sure, it is not for widows or orphans. But the basics can be mastered quickly, especially since spread betting has opened the market up to retail investors, making it more accessible than ever. And even if you don’t fancy trading, it’s worth at least understanding what drives the markets.

How does forex investing work?

Stock markets around the world can all fall at the same time, but because currencies are valued relative to one another, if one weakens then another must get stronger. That means there is always money to be made.

First off, you place currency bets in pairs. Spread betting firms, such as IG Index and Capital Spreads, will allow you to do so. Choose a currency pair, say sterling (GBP) against the US dollar (USD). You buy it if you think the pound will rise (strengthen), and sell it if you think the pound will drop (weaken). The key point to note is that when you ask to buy or sell, your instruction refers to the currency on the left of the quote. So ‘buy GBP/USD’ is a bet that the pound will do well against the US dollar.

You then decide how much to bet per point (a point represents the last digit in a standard quote). So, for example, you could buy the GBP/USD pair for £5 a point, having been quoted a spread of 1.9850/1.9853. If sterling strengthens you might close your position by selling the same pair, now quoted at 1.9865/1.9868. Your profit is 12 points (19865–19853 = 12), which is £60 at £5 a point, tax-free. If, of course, sterling had weakened, you would have lost money.

What are the advantages of forex trading?

Unlike stock exchanges, forex is a 24-hour market, so you can trade at any time, unlike with stocks which can only be traded during market hours. Also, as noted above, currencies are a relative game, so “there’s always a bull market somewhere”, as traders like to put it.

Trading individual currencies also requires a decent knowledge of the factors that could influence exchange rates, so currencies can also give you a way to play changes in sentiment driven by big macroeconomic moves. For example, one of the big drivers is expectations about relative interest rates – a rising Bank of England base rate, relative to the equivalent US Fed rate, would usually make sterling attractive relative to the dollar and push the GBP/USD rate up. So if you have a view on interest rates which differs from market expectations, you can profit from that by betting on the currency markets. There are of course a host of other factors that will move currencies, such as data on government debt, economic growth and inflation among others.