What Is Forex Trading?
The global stock market is huge. The total market cap hovers around US$90 trillion, with over $200 billion in daily trading volume.
That's a lot of cash changing hands, but it's chump change compared to what's happening in the foreign currency exchange (forex) world.
In 2021, the daily trading volume of forex surpassed $6.6 trillion — while the global forex market cap exceeded $2.4 quadrillion.
Since the forex market is more than 26 times the size of the stock market, why does nobody really talk about it?
For that matter, what is forex? How does forex trading work? Why is there no centralized exchange for forex trading? Finally and most important, how can you make money on forex trading?
The Short Version
- Forex is short for foreign exchange and refers to traders who buy and sell different national currencies.
- Forex trades are made through pairs, with investors swapping one currency for another in the hopes that the swapped currency goes up in value.
- The forex market is one of the biggest investing markets in the world but very few retail investors trade forex due to its complexity and high risk.
- Around 90% of retail forex traders lose money, so if you're going to trade forex, make sure to do your research and only invest a small amount.
What Is Forex?
Forex (FX) is shorthand for “foreign exchange.” More specifically, it's the trading of one national currency for another.
If you've ever exchanged dollars into euros or Canadian dollars, you've technically performed a foreign exchange. In a way, anyone who's traveled outside the U.S. is a forex trader.
But forex trading goes way beyond just withdrawing taxi and cheese money at Charles de Gaulle airport. Big players, including commercial banks, hedge funds and governments, are heavily involved in FX trading. They continually swap one currency for another in order to maximize profit.
Global forex trading is an immensely fascinating and complex world of investing hidden in plain sight. Forex trading affects our daily lives in both seen and unseen ways.
If the value of the Vietnamese dong plummets, it may be cheaper to fly to Vietnam for tailored clothes than to buy them down the street in America.
You may be wondering if giving investors access to the global forex market has political ramifications — like if an American hedge fund swapping massive amounts of Chinese yuan for Zimbabwean dollars affects the global economy.
The answer is yes, it does. And it creates quite an interesting mess. We'll talk more about that in a bit, but first, let's start with the basics. What does an FX trade look like?
What Does a Forex Trade Look Like?
Forex trades are made in “exchange rate pairs,” or just “pairs” for short. To give an example, a very common pair is USD/EUR (U.S. dollar and euro).
As mentioned, you may have already made this forex trade yourself. When you did, your goal was convenience. You wanted a currency that you could use on the streets of a foreign country and were willing to pay a fee and lose value in the trade.
But most forex traders are seeking profit. As a professional forex trader, you'd swap currency A for currency B because you think currency B will go up in value compared to A.
For example, let's say you're a British forex trader in early 2016 and you see the writing on the wall with Brexit. The British pound (GBP) is trading for 1.50 U.S. dollars (USD). But you think the vote is going to go pro-Brexit, and as a result, the GBP is going to tank on the global FX market.
So just before the Brexit vote in June, you make a sly trade:
- 1,000,000 GBP for 1,500,000 USD.
By late June, your predictions come true. Your fellow countrymen and women vote pro-Brexit and the GBP plummets to 1.20 USD in value. Therefore, once the GBP hits rock bottom on the forex market, you follow up with a second trade:
- 1,500,000 USD for 1,250,000 GBP
Congrats! You've just made 250,000 pounds Sterling on a forex trade. Enjoy your new Bentley.
This of course is a very rudimentary example and doesn't account for fees, demand, delays, etc. But hopefully you get the point — there's a lot of money to be made in the forex market.
How Does Forex Trading Affect the Global Economy?
The foreign exchange market can be a massive liability for the central banks of small and/or developing nations. That's because it's their job to keep the exchange rate stable between their national currency and other currencies.
A stable exchange rate is like having low crime rates. Each greatly encourages trade, tourism and foreign investment. But an unstable exchange rate scares everyone away. Worse, it can spill over into other countries and create a crisis.
A classic example of this is the Asian Financial Crisis of 1997, aka the “Asian Contagion.” For a myriad of extremely complex reasons, forex investors dumped the Thai baht in the late ’90s in favor of the rapidly strengthening USD under Alan Greenspan.
The weakened baht led a “capital flight,” with investors in all sectors (forex, real estate, stocks) pulling their money out of Thailand. This in turn destabilized the currencies of other Asian countries, including in Malaysia, Indonesia and South Korea. The crisis didn't start reversing course until the International Monetary Fund (IMF) intervened with $110 billion in short-term loans.
The Asian Contagion taught many nations to begin building up a defense against “attacks” from the global foreign exchange market.
Many central banks now have what's known as “foreign exchange reserves” — big piles of cash they can purposely inject into the forex market to restabilize their national currency. This risky action is called a “foreign exchange intervention.”
Case Study: The Swiss Franc
Switzerland is the most expensive country in the world — largely due to the enduring strength of the Swiss franc on the forex market.
Interestingly, the franc would be even stronger if Switzerland's central bank, the Swiss National Bank (SNB), didn't keep intervening.
Forex investors love the Swiss franc because it tends to ride out global crises better than other currencies. When financial markets are volatile, traders convert everything into francs and wait for things to settle down.
It's no coincidence, then, that FX trading volume for the Swiss franc skyrocketed in 2008 (Financial Crisis) and again in 2020 (COVID-19 epidemic). But the popularity of the franc created a big problem for the SNB. The franc was suddenly way overvalued.
So what's wrong with the Swiss franc being so powerful? Doesn't this make Swiss citizens richer overnight?
Yes, but it's a big problem for Swiss businesses. Now nobody can afford Swiss products, Swiss labor or Swiss imports. Nobody shops in Swiss stores because it's cheaper to buy it from literally anywhere else. In short, overvalued currency can obliterate domestic spending and investing.
To muscle the franc back down, the SNB injected US$118 billion worth of foreign exchange reserves into the FX markets. It worked, but it angered forex investors.
One forex investor in particular, the U.S. Treasury, is not a fan of FX interventions. In fact, the Trump Administration directly accused the SNB of market manipulation. It stated that by devaluing the franc, the SNB was interfering with the free forex market and giving an unfair advantage to Swiss exporters.
Suffice to say, the world of forex trading is high stakes, drama filled, and barely regulated. And it pits entire countries against each other in a never ending battle of wits and will.
Why Aren't There More Retail Investors in Forex?
You probably know several people who invest in stocks, maybe even a few who dabble in real estate.
But do you know a single forex trader?
Most people don't. Now that you know more about what forex is and how it works, this may seem odd — after all, looking back at my Brexit example, forex trading doesn't seem very complex. I mean, there are only 180 currencies to trade. Compare that to over 4,000 stocks and millions of real estate properties to consider.
Plus, the forex market is bigger than stocks — 26 times bigger to be exact. And finally, forex is a much easier concept to grasp than cryptocurrency and blockchain.
So why aren't there more retail forex investors?
There are a few reasons forex hasn't attracted the attention that stocks, real estate and crypto have as investment vehicles. Here are just a few of them:
1. There's No Central Marketplace for Forex Trading
The stock market has Wall Street but there's no central “hub” for forex trading. Not even online. In fact, forex trading tends to happen across hundreds of exchange sites, most of which retail investors don't have access to.
The few forex sites that do exist for retail traders are clunky and out of date by modern standards. The #1 FX site in the U.S., forex.com, has met with middling critical reception for being unintuitive, challenging for beginners and charging high fees to anyone but the most active, high-volume traders.
2. There's a Lack of Educational Resources
There's an endless supply of resources online for how to get started investing in stocks, real estate and crypto. But there's much less out there to help retail forex investors.
A big reason for that is because forex isn't “easy to learn but difficult to master” like stocks are. Forex is difficult to learn and even more difficult to master.
To illustrate, here's an excerpt from a popular post within the r/Forex subreddit, where a veteran forex trader breaks down stop loss theory in basic terms (well, basic for the forex crowd):I could explain what all of that means — what “pips” and “resumed run-ups” are — but it would take me several more articles.
And that's the point. A forex how-to simply can't be condensed into a single, 10-minute article. And in fact, that Christmassy yet intimidating candlestick chart above leads nicely into factor #3.
3. Forex Is Deceptively Complex and Has a Steep Learning Curve
To the less experienced eye, the game of poker may seem pretty straightforward. After all, there are only 52 cards in a deck — how hard can it be to win money?
The same logic could apply to forex investing. Yes, there are only 180 currencies out there (and some sites let you trade only 80 pairs) — but knowing when to raise, call or go all-in can take decades of study and practice.
To consistently win at forex investing you have to be able to predict the behavior of a national currency — a figure that can be influenced by that nation's stock market, all of its industrial sectors, its political maneuvering and countless other factors.
And keep in mind that forex doesn't have an easy interface. Retail traders like you and me won't have access to most of the data and analytics we'd need to make successful forex trades.
4. Successful Forex Trading Requires Patience and Discipline
One of the most common mistakes new forex traders make is trading too much too quickly. This sort of aggressive trading behavior can be immensely rewarding in stocks and crypto, but it rarely pays off in the forex world.
Instead, most forex experts recommend starting with at least $5,000 (some say $10,000) and risking no more than 1% of your portfolio on a single pair trade. That means that even if you've invested hours into researching and preparing the perfect forex trade, traditional wisdom dictates you still should invest no more than $100 in each trade.
Another challenge facing forex traders is the sheer volume of small losses. Even full-time professional FX traders often suffer a string of losses, which can greatly test their patience and resolve.
If the stock market is like a chaotic, cacophonous Wall Street trading floor, forex trading is like a Shaolin Temple high in the Himalayas — a place of quiet, focus and unmatched discipline.
But even if you put aside the lack of refined marketplaces and the steep learning curve and the monk-like discipline required to succeed at forex investing, most retail traders are turned off by factor #5.
Find out more >>> How to Manage Risk in Forex Trading
5. 90% of Retail Forex Traders Lose Money
Forex trading has a reputation for chewing up newbies and spitting them out.
While researching for this piece, I read a ton of blogs from former forex traders documenting their experiences.
Most were pretty grim.
Reading their testimonials reminded me of that scene from The Tomorrow War when the veterans recanted their harrowing, hopeless fight against the White Spikes.
“You're not ready.”
“90% of us didn't make it back.”
“If you knew what it was like, you wouldn't go.”
There's a common phrase in the forex trading community: 90-90-90. Even retail forex traders with decades of experience use it. It means, “90% of forex traders lose 90% of their money within 90 days.”
Many traders point out that forex trading is like sitting at the high-stakes poker table in Las Vegas:
- You need a lot of cash to start;
- You don't fully understand the game you're playing; and
- You won't realize who you're playing against until it's too late.
Forex trading is an incredibly fascinating high-stakes world of investing that has stayed hidden from most retail investors' eyes. It's amazing to think that every 24 hours, over $6.6 trillion of the world's $2.4 quadrillion dollars gets shifted around between yen, dong and USD. Entire treasury departments are playing 180-way chess against each other, often resorting to devaluing their own currency just to stay in the game.
While fascinating to watch and learn about, forex trading may not be a good fit for beginner retail investors. The stakes are high and the learning curve is steep. So make sure to do your research and only invest with a small portion of your funds.
Find out more >>> How to Invest in Forex