What Is Forex And How Does It Work?

Foreign Exchange, also known as forex, is not a difficult concept to explain, but it may be different to what you are used to in other capital markets.

At the root of the biggest difference and the most common potential confusion is simply how forex shares are traded and what exactly it is in reality.

Simply put, forex is the relative value of one currency vs. another currency.

We’ve all been in this position at some time in our lives dealing with currencies on vacation. Let’s say you live in the US and you’re planning to take a vacation in Switzerland.

That means that you’re going to have to convert some spending money. You’re going to have to convert some dollars into francs (USD to CHF). Let’s say the exchange rate for this conversion is 1.2049. What that means is, that it costs 1.2049 francs to buy one single dollar.

Exchange rates are typically carried out to the fourth or fifth decimal place. The fourth decimal place is called a pip. If we move from 1.2049 to 1.2050 then we have moved up one pip.

This is commonly used nomenclature in forex trading.

Now, for example, we’re going to turn 500 USD into francs at this particular exchange rate. This will give us 602 Francs. This is a simple, basic, foreign exchange transaction.

If you’ve ever travelled abroad this is what you’ve done.

But what if you’re about to go home and you haven’t spent any of your 602 francs?

Let’s say these currencies now have an exchange rate of 1.1000. In this scenario the exchange rate has changed by the end of our vacation and we’ve lost 1049 pips. But this actually worked out in our favour, because what’s really happening here is that we have our 602 CHF and we’re going to convert them into dollars. Now it costs fewer francs to buy a dollar. The franc has increased in value versus the dollar. This is the way a forex transaction works.

However, this increase in the buying power of francs is not necessarily a bad thing for people who live in the US, which can be difficult to understand when you first learn about forex trading.

If we convert this 602 CHF at our new exchange rate, we receive 547 USD. That means that we just made a profit on our vacation example of about 10% on our spending money. The reason that happened is because over the time of our vacation, we were holding an asset that depreciated in value, just like if you held a stock that’s worth francs and it appreciates in value versus the dollar.

We held an asset, the franc, which became more valuable, and then converted it back into our domestic currency so we’re able to walk away with a profit. This is exactly how the foreign exchange works.

You’ll see this type of exchange, -USD/CHF+, charted out like any other capital market, with both increases and decreases in value. When you see the trend going up on the chart then you know that the USD (the currency on the left side of the exchange) is appreciating in value. When the trend is going down the currency on left side is depreciating in value and the currency on the right side is increasing in value. In our vacation example, we decided to return home to the US when the franc was appreciating.

This is what moves foreign exchange rates and as a trader this is what you’re speculating on. You may be speculating over a very short term basis, or long term basis, depending on what kind of trading you prefer with Forex. All of these exchanges take place online, through a margin account, which is of course much easier and much more convenient than having to fly all the way to Switzerland.

Today in Forex trading you will see plenty of headlines related to the European Union and Britain’s exit, with more consternation over how the triggering of article 50 will move ahead. However, luckily for some, the USD has held firm recently. Unlike the British pound (GBP), which has depreciated in value since Brexit was announced.

To get started with Forex, just choose a platform, like CMC Markets, open an account and start trading.