The short version
- A currency pair such as EUR/USD shows how much of the second currency one unit of the first costs.
- Rates move in tiny steps called pips, so retail forex is usually traded in large, leveraged positions.
- If you own overseas shares, exchange-rate moves already affect your returns, whether or not you ever trade forex.
This guide explains how forex trading works for someone who has never placed a currency trade and may never want to. Understanding the basics is still useful: exchange rates move the value of every overseas share you own, and forex adverts are hard to avoid on investing apps. We cover the quotes, the units, the leverage rules and the costs, then look at where currencies meet a long-term portfolio.
The global forex market in brief
The global forex market is where currencies are exchanged: by companies paying foreign suppliers, by travellers, by governments and central banks, by investment funds buying assets abroad, and by speculators. It is not a single exchange. Instead, large banks and dealers quote prices to one another and to their clients electronically, across financial centres in Asia, Europe and North America.
Because one centre opens as another closes, trading runs continuously from Sunday 17:00 to Friday 17:00 New York time. The Bank for International Settlements surveys the market every three years, and its surveys consistently show daily turnover measured in trillions of US dollars, with the dollar on one side of most trades.
Reading a currency quote
Currencies are always priced in pairs. In EUR/USD 1.0850, the euro is the base currency and the US dollar is the quote currency: one euro costs 1.0850 dollars. If the rate rises to 1.0900, the euro has strengthened against the dollar. Buying the pair means buying the base currency and paying with the quote currency; selling it means the opposite.
You will usually see two prices. The lower one, the bid, is what a dealer will pay you; the higher one, the ask, is what you pay to buy. The gap between them is the spread, and it is one of the main costs of trading.
The most traded pairs, called the majors, combine the US dollar with the euro, Japanese yen, British pound, Swiss franc, Canadian dollar, Australian dollar or New Zealand dollar. Crosses, such as EUR/GBP, leave out the dollar. Pairs involving emerging-market currencies usually have wider spreads and bigger swings.
Pips and lots: the units of forex
Major exchange rates rarely move more than a percent or so in a day, so prices are quoted to four or five decimal places. The standard step is a pip: 0.0001 for most pairs and 0.01 for pairs quoted in Japanese yen. A move from 1.0850 to 1.0875 is 25 pips.
Trade size is measured in lots. One standard lot is 100,000 units of the base currency; a mini lot is 10,000 and a micro lot 1,000. For any pair quoted in US dollars, one pip on one standard lot is worth $10. The pip calculator works out the value for other pairs and sizes.
Leverage and margin
Because a 25-pip move on a small position is worth very little, retail forex is almost always traded with leverage: you put up a deposit, called margin, and the provider lets you control a larger position. Regulators limit how far this can go. In the UK, EU and Australia, retail clients can use at most 30:1 on major pairs and 20:1 on other pairs. In the US, the limits are 50:1 on majors and 20:1 on others.
UK and EU rules also require providers to close positions when your equity falls to 50% of the margin required, and retail clients there are protected from ending up with a negative balance. Those protections exist because leverage magnifies losses exactly as much as gains.
An illustrative trade, step by step
The numbers below are made up to show the arithmetic, not taken from any real market.
- You buy 0.4 lots of GBP/USD at 1.2600. That is 40,000 pounds, a position worth 40,000 × 1.2600 = $50,400.
- At 30:1 leverage the margin required is $50,400 ÷ 30 = $1,680. The margin calculator does this for you.
- Each pip on 0.4 lots is worth 0.4 × $10 = $4.
- You set a stop-loss 35 pips below the entry, at 1.2565. If it is hit, the loss is 35 × $4 = $140, plus costs.
- If the pair instead rises 70 pips to 1.2670, the gain is 70 × $4 = $280, before costs.
Notice what leverage does: a 1% fall in GBP/USD would cost 1% of $50,400, which is $504, or 30% of the $1,680 margin. Working backwards from the loss you can accept is safer than working forwards from the profit you hope for, which is what the position size calculator is for.
What moves exchange rates
- Interest rates. When a central bank raises rates, or markets expect it to, holding that currency pays more, which tends to support it.
- Inflation and growth data. Monthly releases such as consumer prices and employment feed straight into rate expectations. Prices react to the gap between the figure and the forecast.
- Risk appetite. In periods of stress, money often moves towards the US dollar, Japanese yen and Swiss franc.
- Trade and capital flows. Over longer periods, a country's trade balance and the appetite of foreign investors for its assets matter too.
How forex trading works through the day
Activity rises and falls through the day. The Asian session, centred on Tokyo, is usually calmer; London is the largest centre; and the overlap between London and New York tends to bring the most volume and the tightest spreads. Positions still open at 17:00 New York time are rolled over to the next day, which triggers an overnight financing charge or credit called swap. Most providers apply three days' swap on one night, usually Wednesday, to cover the weekend.
What forex trading costs
You pay the spread on every trade, sometimes a commission per lot as well, and swap on positions held overnight. Spreads widen around major data releases, at the daily rollover and when markets are thin. Our trading fees guide shows how these costs build up for frequent traders.
Currencies and the long-term share investor
Even if you never trade forex, you own currency risk the moment you buy a share or fund priced in another currency. Consider an illustrative UK investor who buys $10,000 of US shares when GBP/USD is 1.25, so the purchase costs £8,000. A year later the shares are worth exactly the same $10,000, but the pound has strengthened to 1.30. Converted back, the holding is worth £7,692.31, a fall of £307.69, or about 3.8%, with no change in the share price at all. The currency could just as easily move the other way.
Many long-term investors simply accept this as part of owning global assets, since currency swings tend to matter less over long periods than company growth. Some funds offer "hedged" share classes that reduce the effect, at a cost. Either way, it is worth knowing which currency your investments are really in.
Reader questions
Do I need to trade forex to invest in US shares?
No. Your broker converts your money when you buy shares priced in another currency, usually for a fee. That conversion is a currency exchange, but it is not the same as speculating on exchange rates.
Why is forex traded with leverage?
Major currency pairs usually move only a fraction of a percent a day, so an unleveraged position would produce very small gains or losses. Leverage enlarges both, which is why regulators cap it for retail clients.
Is forex open at weekends?
The main market closes from Friday 17:00 to Sunday 17:00 New York time. Any weekend prices you see are quoted by individual providers rather than the wider interbank market.
Sources
- Bank for International Settlements, Triennial Central Bank Survey of foreign exchange markets
- UK Financial Conduct Authority, restrictions on CFDs for retail clients
- US Commodity Futures Trading Commission and National Futures Association, retail forex leverage limits