Forex trading: what it is and how it works
While forex trading implies trading one currency for another – a forex trader’s objective is simply to speculate or predict whether the exchange rate between two currencies is going to move up or down. This is why it’s commonly referred to as a speculative asset class and as all things speculative, it carries a high level of risk. In short, you should never trade with money you can’t afford to lose.
Trading currency pairs
A currency’s strength can only be evaluated by comparing it with another. The exchange rate between two currencies is similarly relative as well. For example, the U.S dollar will have a different rate in relation to the euro and another for the British pound.
Therefore, when you trade forex, you have to first consider which currency pair you wish to trade. The two currencies in the pair will be bought and sold simultaneously (selling one and buying the other) in order to profit from their fluctuating exchange rate.
To explain further, if the euro is looking strong and you expect its price to rise against the dollar, you could buy the EUR/USD pair at it’s current going rate which is 1.1332. This basically means that 1 EUR can be exchanged for 1.1330 dollars. If the exchange rate goes up e.g. by 70 points to 1.1400 this could be a considerably profitable trade – if you manage to close your position before the exchange rate starts dropping again. Timing is very important because the market is constantly moving up and down according to supply and demand, which is always in flux.
If, however, you bought this pair and the market didn’t agree with your assessment and the exchange rate started dropping e.g. from 1.1330 to 1.1250, this would result in a loss unless you kept your position open in hopes that the price will start moving up once again. Keep in mind though that this isn’t always a valid proposition – the rates could continue to drop while your balance runs out and it could be just a matter of time before you are closed out automatically due to your balance dangerously running out.
The great thing about forex trading and the reason why it’s so popular with retail traders is because you can take advantage of dropping exchange rates as well. You are speculating on price changes and not physically exchanging currencies and as such you can actually sell a currency pair without owning it. Therefore, when you can see that a currency is taking a turn for the worse and its exchange rate is tanking, you can open a sell position in order to profit from the downwards movement.
What is a pip in trading?
In forex trading, the movement of exchange rates is calculated in pips (percentage in point). In fact, in the above example, when the EUR/USD rate dropped from 1.1330 to 1.1250 – this is referred to as a 50 pip movement.
As you can see, a pip is actually the fourth decimal in the exchange rate and it’s the smallest change in the value of a currency pair. The differences may seem inconsequential, but forex traders can actually open positions equal to hundreds of thousands of currency units which translates into considerable profits regardless of the small pip difference in price.
What are spreads?
The spread or the fee required by your broker to open a trading position is also expressed in pips. You will soon find out that each currency pair enjoys different pricing, and this will also differ from broker to broker.
It should be obvious that brokers with lower spreads are much more competitive since this is the main cost of trading forex. If a trade doesn’t turn enough of a profit to cover the spread, you have essentially lost money even if your trade turned out to be profitable. Normally, however, spreads are kept to a minimum (less than 3 pips) and shouldn’t be a cause for concern, unless you are on a huge losing streak.
What is leverage?
Remember when we mentioned that forex traders can make a substantial amount of profit even though exchange rates don’t move in great numbers?
Here is where leverage comes into play. Forex brokers provide leverage to clients which is a form of collateral that can boost your purchasing power. Some brokers provide leverage ratios of up to 200:1 which allows you to buy amounts equal to $200,000 with a deposit of only $1,000.
A trade of such a large amount can result in incredible profits even with small pip movements. However, the opposite is true as well. If the market doesn’t move in your favor and you lose the trade, you may end up having to pay back more than you initially invested.
Leverage is definitely a risk factor, but it’s also the main reason why forex trading is so favorable and exciting. When used conservatively and in conjunction with a risk management plan, leverage can significantly magnify your profit potential.