Foreign Exchange (FX) refers to currencies and instruments used in global payment systems. Currency conversion is the lifeblood of international commerce, facilitating cross-border trade and capital flows.

FX manifests as:

Foreign currency deposits in overseas accounts

Negotiable instruments (bills of exchange, checks)

Settlement balances in payment systems

In practice:

• Japanese exporters receive USD payments (FX inflow)

• Chinese tourists convert yuan to JPY (retail FX transaction)

The foreign exchange market is the international trading venue where foreign currencies are exchanged to balance supply and demand. It facilitates the exchange of different currencies at specific exchange rates, enabling global trade and investment. This process allows businesses and investors to operate smoothly across borders. For example, a British company importing goods from the US would convert pounds to dollars through the foreign exchange market to pay for the goods.

1. Unparalleled Scale

As the world's largest financial marketplace, the FX market processes over $7 trillion daily. This immense volume creates exceptional market depth, where large transactions rarely cause price distortions.

2. 24/5 Availability

Operating from Sunday evening (Wellington open) to Friday evening (New York close), the market's global network of trading hubs enables continuous price discovery across time zones.

3. Optimal Liquidity

With participation from central banks to retail traders, currency pairs maintain tight spreads (typically 0.5-2 pips for majors), ensuring efficient execution with minimal slippage.

• Spot Trading

Spot trading is the most basic form of foreign exchange trading. It involves delivering currency on the transaction day or within two business days. The prevailing market price determines rates. Spot trading primarily serves the real-world foreign exchange needs of businesses and individuals.

• Futures Trading

Futures trading involves standardized contracts traded on a futures exchange. In these contracts, parties agree to buy or sell a specific currency at a predetermined rate on a future date. Futures trading can be used for hedging to mitigate exchange rate risks or for speculative purposes.

• Options Trading

Options trading gives the buyer the right, but not the obligation, to buy or sell a specified amount of currency at an agreed-upon price in the future. This allows investors to exercise the option based on their exchange rate expectations.

• Contracts for Difference (CFD)

CFDs are financial derivatives that enable investors to profit from currency-pair price movements without owning the currency. By using leverage, investors can manage larger positions with a relatively small amount of capital, amplifying potential profits and risks. For example, with a 100:1 leverage ratio, an investor can control a $100,000 position with just $1,000. However, if the market moves against the investor, losses will be magnified by the same ratio.

• Currency Pairs

In foreign exchange trading, currency pairs serve as the fundamental trade units. Each pair comprises two distinct currencies: EUR/USD, GBP/USD, or USD/JPY. Within a currency pair, the first currency is termed the base currency, while the second is the quote currency. For instance, in EUR/USD, the euro (EUR) acts as the base currency, and the U.S. dollar (USD) functions as the quote currency. The exchange rate quantifies how many units of the quoted currency are required to purchase one unit of the base currency. If the EUR/USD rate is 1.1000, this signifies that 1 euro can be exchanged for 1.1000 U.S. dollars. 

• Spread

The spread is a vital concept in foreign exchange trading. It represents the difference between the buying (asking) and selling (bid) prices of a currency pair. On a forex trading platform, both the bid and asking prices are displayed. The asking price is higher than the bid price, and the difference between them is the spread. For instance, if the bid price for EUR/USD is 1.0990 and the asking price is 1.1000, the spread is 10 pips (0.0010).

The spread essentially signifies the trading cost. In forex trading, investors can profit only if the currency pair's price movement exceeds the spread. Spreads vary based on currency pairs and trading platforms. Generally, major currency pairs have smaller spreads due to high market liquidity and active trading. Conversely, cross-currency pairs or emerging-market currency pairs may have larger spreads.

• Leverage and Margin

Leverage is a powerful tool in forex trading. It enables investors to control large-scale trades with a relatively small amount of capital. Leverage is typically expressed as a ratio, such as 1:100, 1:200, or 1:500. At a 1:100 leverage ratio, an investor requires only $1 of their funds to control a $100-worth trade. While leverage can amplify returns, it simultaneously heightens risks. If the market moves against the investor, losses will be magnified by the leverage ratio.

Margin is the collateral an investor deposits to open and maintain a leveraged trade. The margin amount is based on the trade's contract value and leverage ratio.

• Long and Short

"Long" (also known as "going long") refers to an investor's anticipation of a currency's appreciation. They buy the currency pair, for instance, USD/JPY, if they believe the US dollar will rise while the Japanese yen falls. The investor aims to sell at a higher price later for profit.

Conversely, "short" (also known as "going short") involves anticipating a currency's depreciation. The investor sells the currency pair without initially owning it, by borrowing from a dealer. After the exchange rate drops, they buy it back and return it to the dealer, profiting from the price difference.

In foreign exchange trading, investors can take long or short positions by directly buying or selling currency pairs, or using derivatives like forwards, options, and CFDs. They must choose the right time to enter based on their market analysis and predictions.

• Stop Loss and Take Profit

Stop loss and take profit are crucial tools in forex trading for risk management and profit realization. Stop loss sets a price level where, if the market moves against an investor's trade, the position is automatically closed to limit losses. Take profit, meanwhile, sets a target price to close the position and lock in profits when the market moves favorably. Proper take-profit levels help investors secure gains and avoid reversals eroding profits.

• Pip

A pip is the smallest unit of price movement in foreign exchange. For most currency pairs, one pip equals 0.0001. However, for yen-based currency pairs, one pip usually equals 0.01. In a standard lot (100,000 units of the base currency) trade, the value of 1 pip is typically $10. For example, if an investor buys 1 standard lot of EUR/USD and the price rises by 10 pips, the profit is $100 (10 pips × $10 per pip). Understanding the concept and calculation of pips helps investors measure trading profits and risks more accurately.

• Slippage

Slippage is the difference between the actual execution price and the expected price after placing an order. In forex trading, it often occurs due to volatility, poor liquidity, or network latency. For example, if an investor intends to buy EUR/USD at 1.1000 but the order executes at 1.1005 due to market fluctuations, the 0.0005 difference is slippage.

Slippage can negatively impact trades by increasing costs for buy orders and reducing profits for sell orders. In extreme market conditions, such as during major economic data releases or geopolitical events, slippage may be more pronounced due to significant price gaps.

To mitigate slippage, investors can choose platforms with good liquidity and trade during favorable hours. Setting appropriate stop-loss and take-profit levels also helps control risks.

• Swap

Swap refers to the interest payment or receipt that an investor may encounter in foreign exchange trading when holding a position overnight (i.e., the holding time exceeds the same-day trading hours). When an investor buys a high-interest-rate currency and sells a low-interest-rate currency, they usually receive swap interest. Conversely, when buying a low-interest-rate currency and selling a high-interest-rate currency, they may need to pay swap interest. Under normal circumstances, the overnight interest is calculated daily from Monday to Friday. However, due to the market closure on weekends, the overnight interest on Wednesday is usually tripled to cover the interest for the two-day weekend.