Forex or foreign exchange trading is one of the most popular forms of financial trading around and has become increasingly accessible to individual traders in recent years, thanks to a combination of technological advances and regulatory reforms.
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As a result, there has been an explosion of advice and information on forex trading, from guidance on key concepts such as stop loss and take profit to analysis and reviews of the best forex trading platforms and brokers. For beginners, however, one of the barriers to forex trading is that there are so many different ways to get involved with this form of trading, and finding which is most suitable for you can be complicated and confusing.
In this article, we will set out the basic options that are available to the forex trader, in order to give you some idea of how each of these methods works, which will hopefully enable you to make more informed and effective forex trading decisions.
What is forex?
Currencies enable us to make local and international purchases of goods and services and are crucial to economic activity all around the world. However, to engage in trade and business across national boundaries, foreign currencies must be exchanged, and these transactions are carried out through the foreign exchange markets.
Currency exchanges, therefore, lie at the heart of much of our economic activity. For example, if you reside in the UK and want to purchase a car from Germany, you will have to pay for the car in euros, either directly or through the UK import company from which you purchase the product. In the latter case, the importer would themselves have to convert the GBP equivalent amount to EUR.
The same is true with the travel sector, which is where most of us will come into contact with forex. A UK tourist in India cannot pay to see the Taj Mahal in GBP because it isn’t accepted there. The visitor must convert their GBP at the current exchange rate for the local currency, which in this case is the rupee.
The absence of a central exchange market is one distinctive feature of this global market. Instead of being handled by one centralised exchange, currency trading is instead carried out electronically over the counter (OTC). All transactions between traders take place through computer networks and these transactions can be made between any two points on the globe.
Currencies are traded in the major financial capitals of London, Frankfurt, New York, Paris, Hong Kong, Tokyo, Singapore, Zurich and Sydney, and the market is open 24 hours a day, five and a half days a week, so when the trading ends in the US, it opens in Tokyo and Hong Kong. The result is that there is always plenty of currency trading volume, and prices fluctuate continually.
As you might expect, currencies are traded in pairs, with the first currency in a pair being the base currency. The value of the base currency is quoted against the second or ‘counter’ currency. Typical examples include GBP/USD, USD/EUR and EUR/GBP.
Currency traders aim to profit from the differences between the two currencies in a pair, or the changes that take place in the currencies’ value. The first approach is based on profiting from different interest rates by buying the currency that has the higher interest rate, and selling or ‘shorting’ the currency with the lower rate. The most common form of forex trading, however, is to attempt to profit from changes in the prices of the currencies in a currency pair.
What is London’s role in forex trading?
London is one of the world’s major financial centres and the London foreign exchange market is arguably the backbone of international trade and investing.
In fact, a survey conducted by the Bank for International Settlements in 2019 showed that forex trading had expanded in London by an enormous 30%since the Brexit vote of 2016, and that London is the global heart of forex trading, claiming an impressive 43% market share of the world’s forex trading, compared with only 17% in the US.
What are the different ways to trade forex?
The popularity of forex trading has meant that trading platforms and brokers have developed lots of ways to trade these markets. These are the main trading types that you can employ with forex in 2023:
1. Currency futures
Futures contracts are agreements to purchase or sell a specific commodity at a predetermined price at a future date. A contract called a ‘currency future’ specifies the rate at which a currency might be purchased or sold and establishes a specific date for the transaction. First created in Chicago in 1972, they have been around for a while, which provides some reassurance for those new to forex.
The futures market is relatively open and well-governed because futures contracts are standardised and exchanged on a single exchange. This ensures that data on prices and transactions are easily accessible, encouraging transparency in the trading of these assets.
2. Currency options
An option is a type of financial instrument. When you buy this type of asset, you have the option to buy or sell a specific asset at a stated price on the expiry date of the option, but you are not obliged to do so. Just as with currency futures, currency options are traded on exchanges. There is, however, a potential disadvantage with currency options as some of these assets can only be traded within limited market hours, and the range and liquidity available is usually lower than with currency futures.
3. Currency ETFs
ETFs are designed by institutions that purchase currencies and hold the currency in a fund. They then allow people to buy shares in the fund on a dedicated exchange, which makes it possible for investors to trade the shares – just as you would with stocks.
A currency ETF gives you the chance to gain exposure to one currency or to a number of currencies. One of the advantages of an ETF is that it enables individual traders to get involved in the forex market via a managed fund, removing the need to make individual transactions.
Currency ETFs have a wide range of uses, from speculating on forex, diversifyingyour portfolio or evenhedging against currency risks. As with currency options, however, the market for currency ETFs is not open on a 24-hour basis. They also attract trading commissions and additional transaction fees.
4. Spot FX
Spot FX are types of currency assets that are traded through an ‘off-exchange’ specialist market, which is also sometimes described as an over the counter or OTC market. This market operates on a 24-hour basis and is a fast-growing market that offers plenty of liquidity.
Technically, it is not a typical market, as there is no central trading hub or exchange. With an OTC market, individual traders buy and sell directly from a counterparty. While currency futures, ETFs and most currency options are traded using centralised markets, spot FX trading involves OTC contracts that are effectively private agreements between two individuals.
Most spot FX trading is carried out with electronic networks. The main market is known as the ‘interdealer’ market, in which FX dealers buy and sell from one another. In this context, a ‘dealer’ is often an institution such as a bank, and the interdealer market is only open to banks, pension funds, large corporations or insurance companies that are able to trade in high quantities.
A spot FX trade is a bilateral agreement to exchange one currency for another. It is a contract and brings with it a binding obligation to either buy or sell a set amount of currency at a price known as the spot exchange rate, or alternatively the current exchange rate.
For example, if you buy EUR/GBP through the spot market, you are buying a contract that guarantees you will receive an amount ineuros in exchange for pounds at the agreed rate. It is important to note that the underlying currencies themselves are not being bought or sold.
Spot transactions are conducted at the current rate but they don’t go through until two business days following the trades. In the language of forex, this is sometimes described as T+2. Most currency pairs are T+2, although you will find some, such as USD/CAD, that are T+1.
5. Retail forex
While most forex traders won’t be able to access the spot FX market, there is, fortunately, another secondary market that offers individuals, or ‘retail’ traders, the opportunity to get involved.
Access is achieved thanks to forex trading providers. These are institutions or companies that trade in the primary OTC forex market on behalf of retail customers. They look for the best prices and then add their profit margin before displaying these prices on their platforms. This has some similarities to the way in whichwholesale and retail companies operate in other sectors of the economy.
These trading providers may sometimes be known as forex brokers, although technically they aren’t true brokers, as a broker is supposed to take the role of a middleman between a seller and a buyer, whereas trading providers act as counterparties. So, if you are buying, the company acts as a seller and vice versa.
In the case of a retail forex trade, you are not trading the original underlying currency but a contract to deliver that currency. It is also a highly leveraged financial asset. Retail forex customers are not able to be involved with leveraged spot FXtrading, but retail forex brokers can do so on your behalf, enabling you to open trading positions worth as much as x50 the initial margin.
Retail forex trades are closed out when you enter an equal but directly opposite transaction through your forex broker. For example, if you had bought US dollars with GBP, the way to close this trade is to sell US dollars for GBP. Technically, this is known as offsetting a transaction. If you end the business day with an open position, this will be rolled over to the next date. You won’t be required to physically deliver the currency stated in the contract – in fact, a retail forex broker will roll the contract over indefinitely.
When positions on these trades are rolled over, interest is paid by or awarded to the trader. These payments are known as rollover fees or swap fees and are calculated by your forex broker and then debited or credited to you.
Remember, retail forex trading is classed as speculative. This means that you are speculating or making bets on the movement of forex, but you are not buying and selling physical currency.
6. Forex spread bet
Trading on forex can be considered a kind of betting and there is a significant crossover between the high end of the sports betting market, particularly spread betting, and the forex markets.
It is no surprise, therefore, to find that one type of forex trading is known as betting. Spread betting is a familiar concept for many financial traders. As with betting, spread betting on financial markets is about trading in derivatives, which means that you don’t take on the ownership of an underlying asset, which in this case is currency. Instead, you are effectively speculating on the direction that you think the price of the asset will move – either up or down.
Spread betting on forex gives you the opportunity to speculate on what you think the future price moves of a particular currency pair will be. The price of the currency pair that is used in your spread bet is related to the price of that pair that can be found on the spot FX market, so it closely mirrors the up-to-date price of the currency without requiring you to enter into contracts.
To make a currency spread bet, you have to decide whether you think the price quoted in the spread betting market will rise or fall, and you then have to decide how much you are prepared to risk per point of movement in the price. Your profit or loss will be determined by how much the price moves and the size of your per-point stake. Effectively, the more correctyou are, the bigger your profit, and the more incorrectyou are, the greater your loss.
Forex spread betting can therefore be extremely risky, and newcomers are always advised to set stoploss positions to avoid generating huge losses. Spread betting on forex is provided by spread betting companies that are regulated by the FCA and the UKGC.
7. Forex CFD
CFD stands for contract for difference, and as with spread betting, this refers to a derivative. Derivatives track the price of an underlying product, giving traders the chance to speculate on whether the asset will fall or rise in value, without having to take ownership of the underlying asset, which in this case is currency.
As the name suggests, when you buy or sell a CFD, you are making a contract, either with a licensed CFD provider or another trader. Under this contract, one party commits to paying the difference in the asset’s value between the start and end of the trade.
Essentially, a CFD is a form of bet on a particular product either rising or falling in value. The CFD provider agrees with you that whoever ‘wins’ your bet will pay the other party the full difference between the price of the asset at the start of the trade and when the trade is closed.
In the case of forex, a CFD is a contract committing to an exchange of the difference in the value of a currency pair between you opening and closing your position. As with spread betting, the CFD price is drawn from the price on the spot FX markets.
The advantage of trading forex CFDs is that it provides you with the chance to trade in either direction, taking both short and long positions on a currency pair, and as with spread betting, if the price moves in the right direction, you make a profit, while you make a loss if the price goes the other way.
IMPORTANT NOTE: While forex trading can be lucrative for those who are skilled in predicting and navigating price movements in the forex markets, it is not for everyone. Newcomers to forex trading are advised to seek advice, to do in-depth research into which trading method is most appropriate for them, to trade through licensed, regulated brokers and to only ever trade forex with money that they can afford to lose.
Trading with leverage just increases the risk by magnifying potential losses. This could result in losing more money than you originally invested. Sudden currency movements can occur from unexpected market events (such as Liz Truss ‘Trussenomics’ or from media announcements). Losses or gains are timeframe specific and it is important to understand the timeframe dimension as well as the risk appetite for any trades.
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