The foreign exchange market, with a daily currency trading volume of over $6 trillion, represents a means of exchanging one country's currency for another. The foreign exchange market is a dynamic global market where exchange rates are in a constant state of flux as national interest rates, economic and geopolitical conditions change.

Although forex trading offers the potential for profit, it also faces unique risks and not all accounts are eligible for forex trading.

Forex Trading Venues

Generally, retail customers have two options when it comes to trading currencies:

1. Futures Market. A futures contract is an agreement to buy or sell a certain quantity of a commodity or financial instrument at a predetermined price on a specified date. These contracts are traded on exchanges, with trading volumes typically limited to major currencies.
2. Forex Market. Most forex trading occurs between institutional participants—banks, brokers, and large intermediaries—known as the interbank market. Retail forex brokers, such as Charles Schwab, use this information to post competitive buy or sell quotes (known as the bid/ask spread), and retail traders can sell or buy currencies in specific increments based on these quotes.

Understand Quotes

Trading in the forex market involves transactions between two different currencies. The rate between them is called a currency pair. The quote of a forex currency pair is the cost of exchanging one currency for another.

For example, if the currency pair of the US dollar (USD) and the Canadian dollar (CAD) is trading at 1.33, then 1 US dollar is equal to 1.33 Canadian dollars. To understand the cost of buying one Canadian dollar, traders need to do the inverse calculation: 1 USD / 1.33 = 0.7519 USD. In this example, the cost of buying one Canadian dollar is slightly higher than 0.75 USD.

Key Terms in Forex Trading:

• Pip: A pip is the smallest price movement in a currency pair. For most currency pairs, a pip is 0.0001, except for currency pairs involving the Japanese yen (JPY). For JPY currency pairs, a pip is 0.01.
• Pip Value: The value of a pip is determined by the size of the trade. Futures contracts are standardized, and their smallest movements are called ticks. For instance, a GBP/USD futures contract is sized at 62,500, so the tick value is 6.25 USD (62,500 x 0.0001 = 6.25 USD). However, forex trading allows for smaller trading units, with the minimum being 10,000 units.
• Major Currency Pairs and Forex: Any currency pair that includes the following actively traded currencies is called a major currency pair: US dollar (USD), Japanese yen (JPY), Euro (EUR), Australian dollar (AUD), Canadian dollar (CAD), British pound (GBP), Swiss franc (CHF), and New Zealand dollar (NZD). All currency pairs involving these currencies and their trades are referred to as forex.
• Forex Spread: At retail forex brokers, the trading cost is usually paid through the bid/ask spread. Major currency pairs typically have smaller spreads, while forex currency pairs usually have lower liquidity and larger spreads.

Leverage in Forex Trading

Forex trading involves leverage, which means that traders can establish large positions with a relatively small amount of capital. When buying or selling retail forex or forex futures, traders do not use the entire nominal value but are required to pay an initial margin.

The margin requirement is typically 3% to 5% of the nominal amount, but for some currency pairs, it might be as low as 2%. Leverage can magnify profits as well as losses, so traders need to carefully consider their risk tolerance before engaging in forex trading.

Holding Forex Positions Overnight

Forex interest rates are based on the interest rate differential between the currency pairs. When a position is held overnight until the next day, traders earn interest on the long currency and pay interest on the short currency. The difference between these two is called the "net financing rate." Some traders close their positions before the end of their trading day to avoid the risk of the net financing rate.