Forex trading works by buying one currency and selling another at the same time through a currency pair. Traders aim to profit when the exchange rate moves in their favour. Retail forex trading usually takes place through an online broker or dealer, often with leverage. The main costs are spreads, commissions and, in some cases, financing charges. Most retail spot forex trading takes place over the counter rather than on a central exchange.

The regulatory details in this guide should be checked against the rules in force on ****.

Forex Trading at a Glance

Element What it means
Currency pair The two currencies being exchanged, such as EUR/USD
Base currency The first currency in the pair, such as EUR
Quote currency The second currency in the pair, such as USD
Buy or "go long" You expect the base currency to rise against the quote currency
Sell or "go short" You expect the base currency to fall against the quote currency
Main costs Spread, commission and possible financing charges
Main risk Leverage can increase both profits and losses

What Is a Currency Pair?

A currency pair shows the value of one currency relative to another.

For example:

EUR/USD = 1.1000

This quote means that one euro is worth 1.10 US dollars.

  • EUR is the base currency.
  • USD is the quote currency.
  • If EUR/USD rises, the euro has strengthened against the US dollar.
  • If EUR/USD falls, the euro has weakened against the US dollar.

When you buy EUR/USD, you buy euros and sell US dollars. When you sell EUR/USD, you sell euros and buy US dollars.

Commonly traded pairs include:

  • EUR/USD: euro against the US dollar
  • GBP/USD: British pound against the US dollar
  • USD/JPY: US dollar against the Japanese yen
  • USD/CAD: US dollar against the Canadian dollar
  • AUD/USD: Australian dollar against the US dollar

How Does a Forex Trade Work?

1. Choose a Currency Pair

You choose a pair based on the market you want to analyse. Your decision may involve interest-rate expectations, economic data, central-bank policy, political developments or broader market sentiment.

2. Decide Whether to Buy or Sell

If you expect the euro to strengthen against the dollar, you might buy EUR/USD.

If you expect the euro to weaken against the dollar, you might sell EUR/USD.

Forex trading allows you to take positions in both rising and falling markets. The direction of the trade depends on which currency you expect to strengthen.

3. Check the Bid and Ask Price

A forex quote normally contains two prices:

  • Bid: the price at which you can sell.
  • Ask: the price at which you can buy.

The difference between the bid and ask is the spread. It is a trading cost because you usually open a position at a less favourable price than the price available when you close it.

In over-the-counter retail forex, the dealer provides the trading platform and may act as the counterparty to your trade. The Commodity Futures Trading Commission advises retail customers to check a dealer's registration and understand its fees, execution conditions and withdrawal rules.

4. Choose a Position Size

Your position size determines how much each price movement affects your account.

Suppose you buy €10,000 of EUR/USD at 1.1000:

  • If EUR/USD rises to 1.1050, the gross gain is approximately $50.
  • If EUR/USD falls to 1.0950, the gross loss is approximately $50.

The final result would also include the spread, commissions and any applicable financing charges.

5. Use Margin and Leverage

Margin is the money required to open and maintain a leveraged position.

Leverage allows you to control a larger position than the cash deposited in your account. For example, a 2% margin requirement would allow you to open a $100,000 position with $2,000 of margin.

Leverage increases potential gains relative to your deposit, but it also increases potential losses. If the market moves sharply against you, the broker may require additional funds or close the position.

For US retail OTC forex trading, CFTC rules referenced in its customer advisory require a security deposit of at least 2% for major currency pairs and 5% for other pairs. These requirements correspond broadly to maximum leverage of 50:1 and 20:1. Rules and product availability vary by jurisdiction and account type.

6. Close the Position

You complete a forex trade by taking the opposite position.

For example:

  1. Buy EUR/USD.
  2. EUR/USD rises.
  3. Sell EUR/USD to close the position.
  4. The price difference, after trading costs, determines the profit or loss.

A broker may close your positions automatically if your account no longer has enough margin to support them.

What Causes Currency Prices to Move?

Exchange rates are shaped by supply and demand in the foreign exchange market. The Bank of England describes an exchange rate as the price of one currency in terms of another. Market demand can be affected by interest rates, economic conditions and investor confidence.

The main influences include:

  • Interest rates: Higher expected returns on assets in a country can increase demand for its currency.
  • Central-bank policy: Decisions and guidance from institutions such as the Federal Reserve and the European Central Bank can change currency expectations.
  • Inflation: Differences in expected inflation can affect the future value of currencies.
  • Economic growth: Stronger economic prospects can attract foreign investment.
  • Employment and economic data: Payrolls, inflation data and gross domestic product figures can trigger rapid price movements.
  • Political and geopolitical risk: Elections, conflicts and policy changes can affect investor confidence.
  • Market sentiment: During periods of stress, traders may move into currencies they consider safer.

Markets often react to the difference between actual news and what traders expected. A central-bank rate change that was already expected may cause little movement. An unexpected decision can produce a sharp reaction.

The Federal Reserve notes that changes in the relative attractiveness of US assets can affect the dollar's exchange value.

Where Does Forex Trading Take Place?

Over-the-Counter Forex

Most retail spot forex trading takes place in the over-the-counter market. There is no single central exchange matching every buyer and seller. Instead, traders transact through dealers, banks, electronic platforms and liquidity providers.

The Bank for International Settlements describes spot forex and most foreign-exchange derivatives as OTC products. Dealers act as intermediaries in a decentralised and fragmented market.

This structure means:

  • The broker's price and execution conditions matter.
  • Different brokers may show slightly different prices.
  • The dealer may be the counterparty to the retail customer.
  • Customers need to assess the broker's regulation, financial standing and withdrawal terms.

Exchange-Traded Forex Futures

Forex futures are standardised contracts traded on regulated exchanges such as CME Group. They have defined contract sizes, expiry dates and exchange rules. CME Group lists currency futures with standardised specifications and clearing through CME Clearing.

Feature Retail OTC Forex FX Futures
Trading venue Broker or dealer platform Regulated exchange
Contract terms Often flexible Standardised
Counterparty structure Dealer may be the counterparty Exchange clearing system
Expiry Often rolling, depending on the product Defined expiry
Pricing Broker-specific quote Central exchange order book

The legal and tax treatment depends on the country and the specific product. ****

How Do Forex Brokers Make Money?

Forex brokers and dealers may earn money through:

  • Bid-ask spreads
  • Per-trade commissions
  • Financing or rollover charges
  • Markups on the underlying market price
  • Other account or transaction fees

The CFTC states that retail forex dealers may earn money from customer trading activity, fees, spreads and commissions. It also warns that customers in OTC forex trade against the dealer rather than directly on an open exchange.

This does not automatically mean a broker is acting improperly. It does mean that regulation, pricing and execution policies deserve close attention.

What Are the Main Risks?

Leverage Risk

Leverage can turn a small price movement into a large gain or loss relative to your deposit. The CFTC warns that retail traders can lose all of their margin and may be liable for losses beyond their initial deposit, depending on the account and the protections that apply.

Spread and Transaction Costs

A strategy can lose money even when the market moves in the expected direction. The movement may not be large enough to cover the spread, commission and financing costs.

Volatility and Slippage

Prices can move quickly after economic announcements or unexpected events. An order may be executed at a different price from the one displayed when the order was submitted.

Counterparty and Fraud Risk

In the OTC market, the dealer controls the platform and is involved in executing or offsetting the customer's trade.

US traders should check a firm's CFTC and National Futures Association registration before depositing funds. The CFTC warns against unregistered offshore dealers, guaranteed-return claims and demands for extra money before a withdrawal is processed.

A Simple Forex Trade Example

Assume:

  • Pair: EUR/USD
  • Entry price: 1.1000
  • Position size: €10,000
  • Direction: Buy

If EUR/USD rises to 1.1050, the euro has gained 0.0050 against the dollar. On a €10,000 position, that equals an approximate gross gain of $50 before costs.

If EUR/USD falls to 1.0950, the approximate gross loss is $50 before costs.

The calculation is:

Profit or loss = position size × change in exchange rate

Leverage does not change the market movement. It changes how much capital is required to control the position, which affects the gain or loss relative to the money deposited.

What Is the Practical Process for a Beginner?

A typical process is:

  1. Learn how currency pairs, spreads, margin and orders work.
  2. Choose a broker or futures provider regulated in your jurisdiction.
  3. Check the product's costs, leverage, execution rules and withdrawal terms.
  4. Use a demo account to practise order entry and risk controls.
  5. Select a currency pair and write down why you are entering.
  6. Set the position size before placing the trade.
  7. Decide where the trade is invalidated and where you will exit.
  8. Monitor the position and close it according to your trading plan.
  9. Review the result after accounting for spreads, commissions and financing.

The mechanics are straightforward. The difficult part is managing the position size, costs, leverage and broker risk before the trade is placed.