Investment It’s the largest market in the world, but also the most volatile and the hardest to understand. David Budworth explains how it works

Trillions of pounds change hands every day and fortunes are made and lost in the blink of an eye on the foreign exchange (forex) market.

It’s a market that few private investors know how to access or dare to dabble in. The only contact most people have with it is when they go on holiday, swapping pounds for euros or dollars.

However, internet trading means that, in practical terms, it is no more difficult to trade currencies than shares or commodities, but making a profit from the enterprise is a different matter. Any investor who decides to speculate in this most volatile of markets needs to go in with his eyes wide open.

Exchange rates do not move quickly in conventional terms. It is not unusual for a share price to fall 10 per cent in a day. The same percentage point fall in a currency would more likely take months.

However, in the forex market fractional movements in price — called “pips” — can leave you with crippling losses. Even “successful” traders often lose more times than they win.

It is not a comfortable place for the small-time investor, either. Industry insiders such as Agustin Silvani, the author of Beat the Forex Dealer, say that the odds are stacked against investors, especially the novice.

Rather than charging commission for every trade, forex brokers make money from the spread — the difference between the buying and the selling price. Even a fraction of a percentage point difference in the spread can boost the profits of the broker at the clients’ expense. If you are not careful, the only winner from your foray into the market could be your broker. If all this hasn’t scared you off, here are the basics you need to get started in forex trading.

What is it?

Forex is an over-the-counter market, which means that brokers and dealers negotiate directly with one another rather than using a central exchange. As a result, it is open 24 hours a day, five days a week, closing for business only at weekends.

Though it was established to allow international trade to take place, most transactions nowadays are speculative and made by investment banks and hedge funds.

How do I trade?

You can trade on a “spot basis” through a retail forex broker such as FXCM, Interbank FX, FxPro and Saxo Bank. Bookmakers such as CMC Markets and IG Index allow you to spread bet on currencies. Some require you to deposit thousands of pounds before you can start trading, while others let you start with only £50. However, bear in mind that because trading can be volatile if you start with a relatively small sum of money you could lose it all very quickly.

What do you trade?

You trade in pairs, buying, or going long, in one currency and selling, or going short of, another. In other words you are speculating on the chance of one currency appreciating in value in relation to the other. The first currency of a currency pair is called the base currency and always has a value of 1. The second currency is called the quote currency.

You will see two figures for the quote currency. The sell or bid price is on the left and is the price at which you can sell the base currency. The buy or offer price is on the right and is the price at which you buy the base currency.

For example if the pound/US dollar rate is 1.6043/1.6046 you can sell £1 at $1.6043 or buy £1 at $1.6046.

What are the most popular pairs?

Those involving the pound, US dollar, euro and yen. However, traders are always on the lookout for new opportunities.

Brendan Callan, the president of FXCM Europe, says: “Turkish lira and the South African rand have been getting a lot of attention because of the high interest rates in those countries.

“Interest rates are going to be the big story this year. All eyes are on which central banks are going to be raising rates first.”

What is a pip?

It is usually the smallest price change that is registered on the forex markets. Pip is short for percentage in point and usually stands for 1/100th of 1 per cent of a currency. The only exception is for the Japanese yen, where it stands for 1/100th of the yen.

A number of brokers offer fractional pip trading, enabling investors to buy and sell in even smaller increments.

How much do I have to buy?

The standard minimum transaction size in the forex market is 1 lot or 100,000 units of the base currency. However, some dealers will allow you to trade in any unit size, down to as little as 1 unit.

Trading on margin is the norm, whether you are buying on a spot basis or spread betting. This means that, instead of paying the full face value, you put up a deposit. If the share price moves in your favour you can make big money from a relatively small stake.

However, it also means that you can incur substantial losses if the market moves against your position. In the worst cases, the broker will make a margin call, demanding that you pay more money into your account to cover your losses.

Is there anything I can do to limit risk?

Brokers, similar to most forex brokers uk, and spread-betting bookmakers recommend that you put stop-losses in place. These close your position if your bet goes wrong.

Because you can make and lose money fast, most traders hold a position for no more than a few days at most. It is worth bearing in mind that you will usually be charged for holding a position overnight.

How is it taxed?

Spread betting is more tax efficient. You avoid 0.5 per cent stamp duty when you deal, and profits are exempt from capital gains tax. Conventional forex trading is subject to tax.

What about regulation?

Any forex broker or spread-betting company that offers services to British citizens has to be regulated by the Financial Services Authority.

Should I go for it?

Michael Hewson, of CMC Markets, says: “It is not an area for the beginner. You need to have proper training and be able to look at and interpret charts.”

Many forex traders use charts to try to spot trends. If you don’t want to rely on technical analysis you need to have a good grasp of global economics. Expectations of changes in interest rates, gross domestic product growth and other macroeconomic conditions move exchange rates. You need to understand how and why.

Forex trading in action

You are convinced that the pound will strengthen against the dollar. You are quoted a GBP/USD exchange rate of 1.6043/1.6046.

You buy £100,000 at 1.6046 costing $160,460. However, because you trade on margin you have to deposit only a fraction of that amount. FXCM says that it would require only £500 (0.5 per cent of the total position, so the sterling equivalent of $800).

The pound strengthens and the quote rises to 1.6050/1.6053.

You sell £100,000 at the sell rate of 1.6050 and receive £160,500.

You bought £100,000 at 1.6046, paying $160,460. Then you sold £100,000 at 1.6050, receiving $160,500.

That’s a difference of four pips, or $40, which when converted back into pounds is worth £25.