The short version
- A currency pair is the price of one currency expressed in another; you buy one and sell the other at the same time.
- Moves are measured in pips and positions in lots, so a one-pip move on a standard lot of a USD-quoted pair is worth $10.
- Retail forex is almost always leveraged; caps in the UK, EU, Australia and US limit it, but losses still scale with position size.
How forex trading works is easiest to understand with a single quote in front of you. Take GBP/USD at 1.2640: one British pound costs 1.2640 US dollars. Buying the pair means buying pounds and paying in dollars; selling it means the reverse. Everything else in currency trading, from pips and lots to margin and overnight fees, is built on that one idea.
How forex trading works: reading a quote
The first currency in a pair is the base and the second is the quote currency. Prices are shown as two numbers: the bid, at which you can sell, and the ask, at which you can buy. The gap between them is the spread, and it is the first cost of every trade. If GBP/USD shows 1.2639 / 1.2641, the spread is two pips.
Pairs are grouped loosely by how heavily they trade. The majors all include the US dollar (EUR/USD, USD/JPY, GBP/USD and a few others). Crosses leave the dollar out, such as EUR/GBP. Exotics pair a major currency with that of a smaller economy and usually have much wider spreads.
Pips, lots and what a move is worth
Exchange rates move in small steps. A pip is 0.0001 for most pairs and 0.01 for pairs quoted in Japanese yen. Position sizes are counted in lots:
| Size | Units of base currency | Value of one pip on a USD-quoted pair |
|---|---|---|
| Standard lot | 100,000 | $10.00 |
| Mini lot | 10,000 | $1.00 |
| Micro lot | 1,000 | $0.10 |
For pairs where the dollar is not the quote currency, the pip value has to be converted. On USD/JPY at 150.00, one pip on a standard lot is 1,000 yen, which is about $6.67. The pip calculator handles the conversion for any pair.
Who you are really trading with
The wholesale currency market is a network of banks and large dealers. Private traders reach it through a broker. Before you deal with any forex company, it is worth knowing which of two broad models it uses. An agency broker passes your order to liquidity providers and earns a commission or mark-up. A market maker takes the other side of your trade itself and earns from the spread, which means it can profit when clients lose. Both models are legal and common when properly regulated; what matters is that the firm is authorised, keeps client money separate and tells you how it executes orders. In the UK and EU most retail forex is offered as a CFD, a contract on the exchange rate rather than an exchange of actual currency.
Leverage and margin, with the numbers
Because currencies usually move by fractions of a percent in a day, forex is normally traded with leverage. Retail limits are 30:1 on major pairs in the UK, EU and Australia and 20:1 on other pairs; in the US the caps are 50:1 on majors and 20:1 on others.
Illustration: half a standard lot of GBP/USD at 1.2640 is 50,000 pounds, a position worth $63,200. At 30:1, the broker requires $63,200 ÷ 30 = $2,106.67 of margin. A 1% move in the exchange rate changes the position's value by $632, which is 30% of that margin. That ratio is the whole story of leverage: it multiplies gains and losses on your deposit by the same factor. You can test other sizes in the margin calculator.
The forex trading week
Forex trades from Sunday 17:00 to Friday 17:00 New York time. Liquidity follows the sun: Sydney and Tokyo open the week, London takes over in the European morning, and New York joins in the afternoon. Spreads are typically tightest when London and New York overlap and widest in the quiet hour around the daily rollover at 17:00 New York time.
A leveraged position held past that rollover is charged or credited a financing amount called swap, based on the interest-rate difference between the two currencies plus the broker's mark-up. Because spot trades settle two days ahead, the swap booked on Wednesday usually covers the weekend and is three times the normal size.
What moves exchange rates
- Interest rates. Central banks such as the Federal Reserve, the European Central Bank and the Bank of England set short-term rates. Expectations of higher rates tend to attract money to a currency.
- Inflation and jobs data. These shape rate expectations and arrive on a published calendar, so volatility clusters around release times.
- Trade and capital flows. Countries that sell more abroad, or attract investment, create demand for their currency.
- Risk appetite. In turbulent periods money tends to move into the US dollar, the Japanese yen and the Swiss franc.
A worked trade from entry to exit
Illustrative numbers only. You buy 0.5 lots of GBP/USD at 1.2640, set a stop-loss at 1.2600 and a target at 1.2720.
- One pip on 0.5 lots of a USD-quoted pair is worth $5.
- The stop is 40 pips away, so the planned loss is 40 × $5 = $200.
- The target is 80 pips away, so the planned gain is 80 × $5 = $400.
- A spread of 1.5 pips costs 1.5 × $5 = $7.50 the moment the trade opens.
Working backwards from the loss you can accept is what the position size calculator does, and it is the habit that keeps a single bad trade from doing lasting damage.
Spot, forwards and currency futures
Most retail forex is quoted as "spot", but the wider currency market also trades forwards, private agreements to exchange currencies on a later date at a rate fixed today, and currency futures, standardised versions of the same idea traded on an exchange. Companies use forwards to lock in the cost of future imports or the value of overseas sales. The forward rate differs from spot by the interest-rate gap between the two currencies, which is the same force behind the overnight swap on a retail position. Futures are held in a separate futures account with daily settlement.
Mistakes that cost beginners most
- Sizing by the deposit, not by the stop. Opening "a lot" because the margin allows it, rather than calculating what the stop-loss would cost.
- Moving the stop further away once a trade goes wrong, turning a planned small loss into an unplanned large one.
- Trading straight through big data releases without realising that spreads widen and prices can jump past a stop.
- Forgetting swap on positions held for weeks, where the nightly charge can outweigh a modest gain.
- Trusting a stranger's signals. Paid signal groups and online "account managers" are a common route into fraud; see how to spot trading scams.
Each of these is a sizing or discipline problem rather than a forecasting problem, which is good news: they can be fixed before a trade is placed.
Why a stock investor should care about currencies
Even if you never trade a currency pair, exchange rates reach your portfolio. Suppose a UK investor puts $10,000 into US shares when GBP/USD is 1.25, a cost of £8,000. The shares end the year flat, but the pound strengthens to 1.30. The holding is still worth $10,000, yet that is now only £7,692.31, a loss of £307.69 or about 3.8% in pounds. The reverse happens when the dollar strengthens. Currency moves also change the reported profits of multinational companies, which is why earnings reports often quote growth "in constant currency".
Reader questions
How much money do I need to start forex trading?
Brokers set their own minimums, but the more useful question is how much you can afford to lose. Position size, not deposit size, decides the risk on each trade. Many beginners practise on a demo account with no real money first.
Is a forex company the same as a bank?
No. A retail forex company is usually a broker or CFD provider authorised by a financial regulator. It is not a bank, and your money is protected only by the client-money rules and any compensation scheme in its jurisdiction.
Why is my swap charge three times larger on Wednesdays?
Spot currency trades settle two business days after the trade date, so a position held over Wednesday night settles across the weekend. Brokers therefore book three days of financing on that night.
Sources
- UK Financial Conduct Authority, retail CFD leverage limits
- European Securities and Markets Authority, CFD product intervention measures
- US Commodity Futures Trading Commission and National Futures Association, retail forex leverage rules