Many will have heard of the Foreign exchange markets before and may have even come into contact with them when travelling or sending money abroad. However this is about as far as most people’s understanding of the Foreign Exchange markets goes. In this article we aim to properly introduce Foreign exchange trading, allowing you to take your first steps towards trading the Foreign exchange markets.
How Do You Make Money From Forex Trading
The Foreign exchange market is the place where various organisations and individuals, buy and sell currencies. Placing a trade in the Forex markets is a very simple procedure and the actual mechanics of trading doesn’t differ that significantly from other forms of trading. If you have experience with other forms of financial trading, you should be able to pick up the mechanics of Forex trading in no time.
The goal of Foreign exchange trading is to exchange one currency for another in the hopes that the price of one currency will move in your favour, so that the currency you bought will increase in value in comparison to the currency you sold.
Take a look at the following example of GBP/USD (Great British Pound/US Dolalr) trade:
- The trader buys £1,000 (costing him $1540) at the GBP/USD exchange rate of 1.54000.
- When the trader closes the position two weeks later the exchange rate, for the GBP/USD has rise to 1.6000.
- The trader gets back $1600, making himself a total of $60 profit ($1600 – $1540).
- Exchange rates are simply the ratio at which one currency is traded against another. The USD/JPY pairing is an illustration of how many Japanese Yen you can buy with one single US Dollar. Vice versa it also shows you how much Japanese Yen it would take to buy one US Dollar. The fluctuations in these exchange rates allow traders to make a profit, when the price moves in his favor.
Reading Currency Quotes
You will always find currencies quoted in pairings, the four major pairings are the EUR/USD, GBP/USD, USD/CHF and the USD/JPY. To find out more about currency pairing codes, I suggest you read my post on ‘What Is Forex’ here. There is a good reason to why you always find currencies quoted in pairings, every time you enter into a foreign exchange transaction you are selling one currency and buying another.
The currency listed to the left (before the slash) is known as the base currency, while the currency listed on the right hand side is known as the quote currency. You will not always find the two pairings separated by a slash, when listed without the slash the above example would look like the following: GBPUSD 1.44710. When you are buying the price tells you how many of units of the quote currency you would need in order to buy one unit of the base currency, in the above example you would need around 1.44 Dollars for each Pound you wanted to buy. When selling the price tells you how many of the quote currency you would get for selling one unit of the base currency.
The base currency is the base for any particular trade. If you were to buy the GBP/USD pairing listed above, you would be buying British Pounds while simultaneously selling US Dollars. You would buy the pairing if you believed that the Great British pound was going to become more valuable in comparison to the US Dollar. While you would sell the pairing if you believed that US Dollar was going to rise in value against the pound.
In trading circles buying a currency pairing is known as ‘going long’ or ‘taking a long position’. When buying you want the base currency to rise, so that you can sell it back at a higher price making a profit. Selling a currency pairing is known as ‘going short’, ‘short selling’ or ‘taking a short position’. When selling you want the base currency to decrease in value against the quote currency, so that you can buy it back at a lower price thereby making a profit.
The Bid and Ask
One thing that often confuses new traders is that they are quoted two different prices for each currency pairing. These prices are the bid and the ask, in the vast majority of cases the bid will be lower than the ask price. The bid is the price at which the brokerage you are using is willing to buy the base currency, in exchange for the listed amount of the base currency. The ask price conversely is the price at which your brokerage is willing to sell the base currency and buy the listed amount of the quote currency.
The difference between the bid and ask prices is known as the spread. The tighter the spread the better, wide spreads make it harder for the trader to make a profit from his/her positions.
Foreign exchange is inherently risky and those who are interested in trading should do thorough research before engaging in trading.