Forex: Why is the world's most liquid market worth understanding?

Question

Many people have heard of Forex (foreign exchange trading), but have little understanding of this largest financial market in the world. Today, let’s take an in-depth look at this market with a daily trading volume of over trillions of dollars.

First, what is Forex?

Simply put, forex trading is the process of buying and selling currencies and their derivatives. Whenever you exchange money at a bank or travel abroad, the exchange rate you see is directly determined by the global foreign exchange market.

This market is powerful because it involves participation from governments, central banks, large financial institutions, corporations, and even individual traders. Factors such as economic conditions, international situations, interest rate policies, and geopolitical events all influence exchange rate fluctuations.

Unique Advantages of the Forex Market

Compared to the stock market, Forex has several obvious features:

Unmatched Liquidity: This is the largest market in the world by trading volume. High liquidity means you can enter and exit trades at any time, with relatively small transaction costs (spreads).

Open 24/7: From Monday to Friday, it operates almost continuously, and some platforms even offer weekend trading. Not limited by time zones, it rotates open in major financial centers like New York, London, Tokyo, Sydney, etc.

Low Barrier to Entry: You can open an account with just a few hundred dollars. Many online brokers support minimum deposits of $100, which is friendly for small investors wanting to test the waters.

Leverage Mechanism: This is a double-edged sword. With leverage, $10,000 can control a position of $100,000 or more. While it can amplify gains, it also increases risks.

How Currency Pairs Work

The foundation of forex trading is currency pairs. Each pair consists of a base currency and a quote currency. For example, GBP/USD:

Base currency is GBP
Quote currency is USD
A quote of 1.3809 means 1 GBP equals 1.3809 USD

The most common trading pairs include USD/JPY, GBP/USD, USD/CHF, and EUR/USD, known as “major pairs.” GBP/USD is also nicknamed “Cable,” originating from the 19th-century transatlantic submarine cable connecting London and New York.

Concept of Trading Size

In forex trading, currencies are traded in “lots.” A standard lot equals 100,000 units of the base currency, but there are more flexible options:

Standard lot: 100,000 units
Mini lot: 10,000 units
Micro lot: 1,000 units
Nano lot: 100 units

Beginners usually choose micro or nano lots to reduce risk. As experience grows, they can gradually increase trading size.

Pips and Profit Calculation

A pip is the smallest price movement in forex quotes. For most currency pairs, 1 pip = 0.0001. The exception is the Japanese Yen, where 1 pip = 0.01.

Some brokers also offer “fractional pips,” adding an extra decimal place to standard precision. For example, GBP/USD might show five decimal places instead of four.

For EUR/USD: Buying 1 lot (100,000 euros) costs about $119,380. When the price rises by 1 pip, the quote currency value increases by $10. A 10-pip move yields a profit of $100.

Leverage is a Double-Edged Sword

Because the profit margins in forex are relatively low (usually only 0.1% to 1% fluctuations), many traders use leverage to amplify trading size and potential gains.

Leverage ratios typically correspond to margin requirements:

10x leverage = 10% margin
20x leverage = 5% margin
100x leverage = 1% margin

For example, using $2,400 with 50x leverage means controlling $120,000 in the market. But the risk is that if the market moves against you by 240 points (equivalent to $2,400), your account will be liquidated.

The Clever Use of Hedging

For traders who want to avoid full exposure to risk, hedging is a smart choice.

Futures Contract Hedge: Suppose you expect to receive $100,000 from the Eurozone but worry about the euro appreciating. You can enter into a futures contract to exchange dollars for euros at a fixed rate (e.g., 1.41) after one year. This locks in your income regardless of exchange rate fluctuations.

Options Hedge: Similar to buying insurance. You pay a premium for the right, but not the obligation, to buy or sell a currency pair at a predetermined price on a specific date. If the market moves favorably, you exercise the option; if not, you let it expire, losing only the premium.

Exploiting Arbitrage Opportunities

There are interest rate arbitrage opportunities in the forex market. Suppose EUR/USD is at 1.400, with euro zone deposit interest at 1%, and US at 2%.

Steps:

Short EUR/USD at 1.400, gaining $140,000
Deposit this amount in a US bank earning 2%
After a year, the total reaches $142,800
Use a pre-agreed futures contract (at 1.41) to convert dollars back to euros
End up with approximately 101,276.60 euros

While the absolute profit may seem small, the real value of arbitrage lies in locking in exchange rate risk and avoiding unexpected losses.

Why do enterprises and individuals participate in Forex?

For enterprises: Import/export trade, overseas investments, and cost planning all require the forex market. Hedging fixed costs helps companies plan international expansion more rationally.

For individual traders:

Leverage amplifies small capital investments
Lower fees and spreads compared to stocks
Flexible trading hours
Can engage in both long-term investments and short-term arbitrage

How to start Forex trading?

The most straightforward way is to buy and hold currency pairs on a broker platform. If you believe a currency will appreciate, buy it and sell later at a higher price.

Advanced strategies include:

Using leverage to enlarge positions
Hedging with futures or options
Developing interest rate arbitrage strategies
Tracking central bank interest rate differentials for long-term positioning

Risk Warning

Although forex trading is full of opportunities, high leverage also means high risk. Many beginners experience rapid margin calls due to misunderstanding how leverage amplifies both gains and losses.

Before entering the market, ensure you:

Fully understand how leverage magnifies profits and losses
Choose regulated, reputable brokers
Start with small trades to gain experience
Develop clear risk management strategies

The door to the forex market is open to everyone. With the proliferation of online broker services and increased competition, the once high and distant Forex is now within reach. But remember, opportunities and risks often go hand in hand.