What Is Forex Trading?

Before looking at pips, lots or leverage, it helps to answer the basic question: what is forex trading? Forex, or foreign exchange, trading involves buying one currency while selling another. Transactions take place in a global, decentralised over-the-counter (OTC) market.

Businesses, central banks and institutional traders use the forex market to exchange currencies, manage international payments or respond to changes in the global economy.

Retail traders usually access the forex market through Contracts for Difference (CFDs). Rather than exchanging physical currency, they speculate on whether the price of a currency pair will rise or fall.

Forex CFDs often involve leverage, which allows traders to control a larger position with a smaller amount of capital. However, leverage can increase both profits and losses. Traders should also understand spreads, overnight fees and other trading costs, as these can affect the overall result of a position.

Success is never guaranteed. Effective forex trading requires a clear understanding of currency pairs, risk management and the costs involved.

Quick Takeaways

• To understand what is forex trading in practice, it always starts with a currency pair, where you speculate on the value of the base currency relative to the quote currency.
• The total cost of a forex trade includes the spread, any commissions and overnight fees, not just the advertised spread.
• Leverage allows you to control a larger position with less capital, but it can increase both potential gains and potential losses.
• The forex market operates 24 hours a day, five days a week. However, liquidity typically falls and spreads may widen during the daily market rollover.

What Are Currency Pairs and How Do You Read Them?

A currency pair shows the value of one currency relative to another. It consists of a base currency (the first currency) and a quote currency (the second currency).

For example, if EUR/USD is quoted at 1.0850, it means one euro is worth 1.0850 US dollars. If you expect the euro to strengthen against the US dollar, you would open a buy position. If you expect it to weaken, you would open a sell position.

Understanding how currency pairs work is one of the first steps in learning what can you trade with CFDs, as forex is one of the most widely traded CFD markets.

Forex currency pairs are generally divided into three categories:

• Major pairs – Include the US dollar, such as EUR/USD, GBP/USD and USD/JPY. They are the most actively traded pairs, typically offering high liquidity and tighter spreads.
• Minor pairs – Also known as cross currency pairs, these include major currencies but exclude the US dollar. Examples include EUR/GBP and GBP/JPY. They are generally liquid but often have slightly wider spreads than major pairs.
• Exotic pairs – Combine a major currency with the currency of an emerging or developing economy, such as USD/MXN or USD/ZAR. They tend to have lower liquidity, greater price volatility and wider spreads, which can increase trading costs.

Major currency pairs are often the starting point for many retail traders because they typically offer stronger liquidity and lower trading costs. However, the most suitable market depends on your trading objectives, risk tolerance and level of experience.

How Forex Trading Works: Pips, Lots, and Going Short

Forex trading is based on small changes in currency prices. These price movements are measured in pips, while trade sizes are measured in lots. Traders can also open positions to profit from either rising or falling markets.

What Are Pips and Lots?

A pip (percentage in point) is the standard unit used to measure price movements in the forex market. For most currency pairs, one pip is the fourth decimal place. For example, if EUR/USD moves from 1.0850 to 1.0851, the price has moved by one pip. For Japanese yen (JPY) pairs, a pip is the second decimal place.

Forex positions are measured in standardised trade sizes known as lots:

• Standard lot – 100,000 units of the base currency
• Mini lot – 10,000 units
• Micro lot – 1,000 units

What Does Going Long or Short Mean?

Forex traders can speculate on both rising and falling prices:

• Going long means buying the base currency and selling the quote currency because you expect the exchange rate to rise.
• Going short means selling the base currency and buying the quote currency because you expect the exchange rate to fall.

Whether you go long or short, your profit or loss depends on how the currency pair moves after you open your position.

The True Cost of Forex CFDs (The "Low Spread" Illusion)

The total cost of trading a forex CFD is not limited to the spread. It can also include commissions and overnight fees, depending on your broker and the type of account you use.

Many CFD brokers advertise ultra-low or even 0.0-pip spreads to attract new traders. While a tight spread can reduce the cost of opening a position, it is only one part of the overall trading cost.

For example, EUR/USD is the most heavily traded currency pair in the world, so it typically has one of the tightest spreads of any pair, though the exact figure varies between brokers, account types and market conditions. On a standard lot (100,000 units), a one-pip move in EUR/USD is worth approximately US$10, so even a small spread creates an immediate trading cost.

If you keep a position open overnight, you may also pay or receive an overnight fee (swap). This charge is based on factors such as the interest rate difference between the two currencies, the broker's financing costs and its pricing model.

For example, if an overnight fee of US$5 is charged each day, holding the position for seven days would add US$35 to your trading costs. Over time, these charges can reduce potential profits or increase losses, particularly for longer-term positions.

When comparing forex CFDs, it is important to consider the total trading cost, including the spread, commissions and overnight fees, rather than focusing on the advertised spread alone.

Market Hours: The 24/5 Market and Rollover Risk

The forex market operates 24 hours a day, five days a week across the major global trading sessions. However, liquidity typically falls during the daily rollover period, which can affect trading costs and execution.

Unlike stock markets, forex is a decentralised over-the-counter (OTC) market. Trading begins on Monday morning in Sydney and continues until the New York session closes on Friday. Activity moves through four main trading sessions: Sydney, Tokyo, London and New York. Trading volume is usually highest when the London and New York sessions overlap, often resulting in greater liquidity and tighter spreads.

Around 5 p.m. New York time, many brokers apply the daily rollover. During this period, market liquidity is typically lower, and spreads may widen temporarily.

If you use tight stop-loss orders, wider spreads during the rollover period can sometimes trigger them even when the underlying market price has changed very little. For this reason, it is worth checking your broker's rollover time and understanding how spreads behave before holding positions overnight.

Leverage and Margin: The Double-Edged Sword

Leverage allows traders to control a larger forex CFD position with a relatively small initial deposit. While this can increase potential returns, it can also increase potential losses.

When comparing CFD vs forex spot trading, one of the main differences is the use of margin. With a forex CFD, you do not need to pay the full value of the position upfront. For example, if your broker offers 30:1 leverage, a position worth US$100,000 requires an initial margin of approximately US$3,333.

Although leverage increases buying power, it also increases risk. A 1% move against a US$100,000 position results in a US$1,000 loss, regardless of the smaller amount of margin required to open the trade. As a result, relatively small market movements can have a significant impact on your account balance.

To help reduce this risk, regulators including the Financial Conduct Authority (FCA) in the UK, the European Securities and Markets Authority (ESMA) and the Australian Securities and Investments Commission (ASIC) limit leverage for retail traders to 30:1 on major forex pairs.

Many CFD brokers also disclose that, in line with FCA and ESMA risk-warning disclosure requirements, around 70% to 80% of retail client accounts lose money when trading CFDs, although the exact percentage varies by broker and is published in each firm's own risk warning.

If your account equity falls below the required margin, your broker may issue a margin call or automatically close open positions to limit further losses.

Leverage can also affect decision-making. Because losses feel more painful than equivalent gains feel rewarding, a bias known as loss aversion, some traders hold losing leveraged positions too long in the hope of a reversal, which can turn a small loss into a much larger one. Being aware of this tendency before you trade is as important as understanding the mechanics of leverage itself.

Conclusion

Understanding what is forex trading is the first step toward speculating on changes in currency exchange rates in the world's largest and most liquid financial market. For retail traders, this is typically done through forex CFDs, which provide access to the market without owning the underlying currencies.

Before trading, it is important to understand how forex CFDs work, including the impact of spreads, commissions, overnight fees and leverage. These costs can affect your overall trading results, particularly if you hold positions for longer periods or trade during times of lower market liquidity.

Leverage can increase both potential profits and losses, so effective risk management is essential. Understanding the costs and risks involved can help you make more informed trading decisions and set realistic expectations.