With a forex trade, you are buying one currency and simultaneously selling another currency, speculating on the future price fluctuations between the two currencies.
Currencies are valued against each other in pairs. For example, the US dollar against sterling would be written as USD/GBP, the dollar in this example is the base currency and the pound is the quote currency or counter currency.
Only a handful of pairs make up the majority of trades in the marketplace; these are the most heavily followed currencies of the major economies which have sensible monetary policy, a stable political situation and low inflation. The most commonly traded currencies in the marketplace are the euro, the US dollar, the pound sterling, and the yen (see graph).
Trades take directional bets on currency price moves, going long or short depending on what they think the base currency will do in relation to the quote currency.
FX trading can be reactive, looking at past price movements and reactions to economic events to determine a strategy, or it can be speculative, looking to future to try to anticipate likely price action.
Most traders will use a combination of technical and fundamental analysis, looking at economic indicators such as GDP, retail sales, inflation and unemployment data, and adding technical analysis to try to identify repeatable patterns. Like any type of trading, FX trading also involves some sentiment and behavioural psychology, with investors’ hunches and intuition coming in to play.
FX traders react extremely quickly to events which may move currency values - this is where stop loss and limit orders may be very useful and may allow them to set a floor under potential losses, and to take profits at the right time.