How does Forex trading work?

Unlike stock and futures markets, foreign exchange trading does not take place on a regulated exchange. Instead, Forex trading occurs between banks on what is known as the over-the-counter (OTC) or interbank market. This global banking network forms a market open 24 hours a day, 5 days a week, without a central physical location or centralized stock exchange.

In Forex trading, there are three categories of currency pairs: major, minor, and exotic. Major pairs account for approximately 80% of the total Forex market volume and include EUR/USD, GBP/USD, USD/JPY, USD/CAD, USD/CHF, AUD/USD, and NZD/USD.

Minor currency pairs link major currencies, excluding the US dollar (EUR/GBP, GBP/JPY, AUD/GBP, etc.). Exotic currency pairs link a major currency with the currency of an emerging market or a less developed or less stable economy. For example, EUR/TRY, USD/SEK, GBP/HKD, etc.

All currencies are always traded in pairs, meaning you buy one currency while selling another. Each currency has its own symbol or code. For example, the code for the Japanese yen is JPY, and the code for the Australian dollar is AUD.

A currency pair consists of a base currency, which is the first currency, and a quote currency, which is the second. For example, for the British pound against the US dollar (GBP/USD), the base currency is the British pound, while the quote currency is the US dollar.

The smallest change in the price of a currency pair is called a pip, short for "percentage in point". In Forex, a pip usually refers to the fourth decimal place of a price change, although for some pairs, it can represent the second or third, or even the fifth decimal place (eg, on USD/JPY).

For example, if the EUR/USD rises from 1.1200 to 1.1201, this means that the currency's price has moved by 1 pip.

Each currency pair also comes with a spread, which simply represents the spread between the bid and ask price, ie, bid and ask. The spread varies between forex brokers and depends on the type of order execution offered by the broker (ECN/STP, market maker, etc.).

For example, a currency pair quote might look like this:

You can observe above a live quote of the EUR/JPY. As you can see, there is a spread between the buy price and the sell price. The price at which you buy the base currency is called the "bid", while the price at which you sell it is called the "ask". Together, these prices make up the bid-ask spread.

Each currency is influenced by things like interest rates, economic data, geopolitical events, and market sentiment. Traders rely on this data using different tools and analysis methods to buy and sell one currency against another. For example, a trader can anticipate a potential weakening of the USD in the short term and buy EUR against the US dollar. This is exactly how Forex trading works.

To better understand how the Forex market works, you can consult all the main currency pairs in the screener below:

How does Forex trading work?