For some investors, the currency market offers an interesting chance to make money. Investing in the currency market can, however, be rather risky. The currency market (also called the forex market) is volatile, and the story can change quickly, depending on the perception of a currency’s value in relation to another. However, for those who have the risk tolerance for it, trading currencies can be an interesting – and sometimes profitable – investing move.
Basics of Forex Trading?
“Forex” stands for “foreign exchange.” The forex market is made up of financial and other institutions, as well as foreign banks. The forex market represents simultaneous transactions of buying and selling currencies. In reality, though, you do not actually “buy” or “sell” anything on the currency market. Instead, what you are doing is more along the lines of speculation, determining how one currency will move in relation to another. When you are right, you profit. When you are wrong, you lose. No physical exchange actually takes place. Instead, forex market transactions are closer to over the counter transactions, handled electronically. When you trade, you use market makers, who are responsible for the bid-offer prices made to clients. The broker makes money on the spread between the bid and the offer, and once you overcome that, you make pure profit. Unless you use additional services, there are usually no commissions in forex trading.
The forex market is open 24 hours a day, from 5 pm Eastern on Sunday to 5 pm Eastern on Friday. The currency market represents the most liquid market in the world, and one in which $1 trillion a day changes hands.
Currencies on the forex market are traded in pairs. There is more to currency trading than just saying that you think the U.S. dollar will rise or fall; you have to specify which currency the dollar will perform well or poorly against. Quotes for the forex market are expressed as pairs: EUR/USD, GBP/USD, USD/JPY, etc. The first currency listed in the pair is the one seen as rising or falling. So, if EUR/USD is said to be falling, it means that the euro is falling in value with relation to the U.S. dollar. The quote is also given in terms of the first currency listed in the pair. If EUR/USD is at 1.4000, it means that the euro is the base currency and that one euro is worth US$1.40, with the U.S. dollar representing the quote/counter currency. It means it takes $1.40 to equal one euro, so the euro is valued more highly. This makes it possible for a currency to both rising and falling at the same time. The U.S. dollar may be gaining against the euro, but at the same time, in a different pair, be falling to the Japanese yen.
You might see the term “pip” used when reading currency news, quotes or learning about pairs. Pip means “percentage in point” and represents the smallest price change available. Most currency pairs are quoted out to four decimal places, indicating that a pip is 1/100 of one percent. The only major exception is the USD/JPY pair, which is quoted to two decimal places, instead of four.
Leverage and forex trading
One of the things that makes forex trading so profitable (when you can manage to speculate correctly) is the leverage involved. Most forex trading market makers and brokers will offer 400-1, meaning that you can use $1,000 to control a position of $400,000. Your profits increase by quite a bit. Lot (or position control) sizes in forex trading tend to be rather large, of about $100,000. You can see where the profits could escalate. When you are controlling a position of $100,000 and the pip changes even in small amounts, that can multiple your winnings. But you have to be careful: Leverage is a double-edged sword that can magnify your losses as well.
You do not have to take the 400-1 leverage offered in many cases. Look for a forex broker that allows you to leverage less. Another thing you can do is open a mini forex account. Instead of requiring you to trade in lot sizes of $100,000, you can instead use smaller $10,000 sizes. Minimum deposits on mini forex accounts are also usually $250, rather than the regular account minimum of $2,500. You can often get the same leverage with a mini forex account, but because of the smaller lot sizes, you often end up with smaller profits.
You may have seen ads stating that trading currency is less risky. Not so. It is very easy to lose a great deal of money in a short amount of time when you play the forex market. If you want some of the gains promised by currencies, but a little less risk, it is possible to invest in currency ETFs. You can limit your forex trading losses with help from stops, hedges, following a system and reducing your leverage. It is a good idea to use money that you can afford to lose when engaging in forex trading.
Miranda is freelance journalist. She specializes in topics related to money, especially personal finance, small business, and investing. You can read more of my writing at Planting Money Seeds.