How To Trade Forex Explained

What is currency trading? Well, at its simplest it is exchanging one currency for another, just as you might do when going on vacation to another country. You trade your own currency for the currency of the country you are visiting.

However, when people talk about forex (foreign exchange) trading or currency trading on the forex market, they generally mean something very different. In this case traders are constantly exchanging one currency for another (buying currencies and selling others) with the aim of making a profit when the exchange rates change.

It is a little like trading in stocks on the stock market. Stock traders usually buy and sell stocks very quickly compared with the average personal investor who will take the advice of a broker but often keep stocks for years or even decades.

How Does Currency Trading Work?

The best way to demonstrate how currency trading makes money for the traders is to use an example.

Let’s say the current rate on the British pound to euro forex market is this: GBP/EUR 1.1200. That means that to buy one British pound you will need 1.12 euros. If you believed that the value of the euro was going to rise compared to the value of the pound, you might sell 100,000 pounds, buy 100,000 euros, and wait. Then let’s say a few days later, the exchange rate has moved to: GBP/EUR 1.0600. Sure enough, the pound is now worth only 1.06 euros. Now if you sell your euros and buy back 100,000 pounds, you will have made a profit of 6% on your cash, less any fees.

This sound like a lot of money. Who has 100,000 pounds or even dollars lying around in the bank to trade with? Not me, and I guess not you either. But fortunately, you do not have to have all that money for real. You are buying and selling at the same time, so all you need to have is enough to cover any loss that might be made before you could exit the market if your prediction was bad and the currency that you bought started to fall. Your broker loans you the rest.

This is called trading margins. On a $100,000 trade the margin is usually 1% or 2%, i.e. $1,000 or $2,000. This is the money that you must have in your forex brokerage account.

The amount you trade is determined by ‘lots’. A lot may be worth $10,000 or more depending on the currency and the Forex broker. So if you want to trade $20,000 you would trade 2 lots and so on.

There are now limited risk accounts, where you can only risk the amount of cash you have on account with the broker, thus avoiding margin calls. This is done by allowing smaller players to trade forex using ‘mini lots’ or fractions of a lot. So you can trade $1,000 by trading 0.10 of a lot. This cuts the risk but may cost more to trade.

More and more ordinary people are getting into Forex trading these days. It has certain advantages over the stock market and even if you know nothing about valuation of the different currencies you can set up a forex trading robot, a complex software program that will trade for you according to the settings you choose. Keep in mind that it is a risky business and money can be lost as well as gained. Knowing what is currency trading gives you an idea of whether you want to take the next step towards becoming a currency trader.

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October 16, 2009 | Filed Under Finance

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