A simple guide to the intricacies of foreign exchange

Some people lose their heads when dealing with the amount of money that leverage puts at their disposal because it seems unreal, so you will need to stay focused.

A simple guide to the intricacies of foreign exchange

One of the fastest-growing areas in trading, forex offers huge opportunities. However, although it’s simple on the surface, it takes most people a while to figure out how to approach it successfully. If you’ve been thinking about giving it a try, what are the key things you need to understand? This guide explains how it works and looks at the key considerations that affect how well you’re likely to fare.

How does it work?

If you’ve ever traveled abroad and exchanged currencies so that you’ll have some money to spend on your trip, then you’ve engaged with forex. You’ve probably also noticed that the bank or other institution through which you changed your money made a healthy profit out of the process.

Every time one currency is exchanged for another, there is money to be made. Forex trading involves making money by predicting how the relative values of two currencies are going to change. Brokers offer a range of different currencies that you can choose from, and although you can only make a tiny profit on each trade, the idea is to trade on a lot of currency units at once.

Prices fluctuate naturally for a variety of reasons related to what’s happening in the global economy, with politics, military conflict, natural disasters and other such events impacting the way that currencies interact.

Currency pairs

Currencies are always traded in pairs, one against the other, and you can bet on them moving in either direction. They are divided (mostly for convenience) into major and minor currencies, depending on the size of the economies with which they’re associated. The price of each currency at any given time is listed to four decimal places because it’s on these very small margins that trading is carried out.

Where most currencies are concerned, the fourth decimal place is known as a ‘pip’ – the exception being the Japanese yen (designated as JPY), where the pip is the second decimal place (taking account of the fact that each individual currency unit is of significantly lower value than, say, the dollar or the euro, though the Japanese economy is still strong).

Brokers list profit potential by the pip, but the amount of profit available on each pip may depend on the volume of them that you purchase.

Leverage

Trading on a large number of currencies at once would, if financed directly by the trader, mean that only the very wealthy could make money from forex. For this reason, forex brokers offer what is known as ‘leverage’, which basically means letting you borrow money at an agreed percentage over the course of each trade.

The amount of leverage available to you may vary based on the amount of your own money that you’re committing to the trade and the length of time that you have been with your broker. It’s important to recognize, however, that just as the use of leverage makes it possible for you to generate large profits, it also puts you at risk of making large losses – larger than the amount of your own money that you put in.

Some people lose their heads when dealing with the amount of money that leverage puts at their disposal because it seems unreal, so you will need to stay focused.

Analysis and prediction

How can you know which direction one currency is going to move in against another? This is where the crux of forex trading lies. In essence, it’s about making predictions based on past behavior, like most forms of trading, but in this case, the focus is very much on the short term. Your forex broker will supply you with charts to help you follow trends and, depending on the trading platform you are using, you may also have other indicators available to you.

These can help you to distinguish minor spikes in interest in buying or selling a particular currency from serious trends substantiated by a significant volume of interest from other traders.

Because most traders use the same approach, trends tend to become self-fulfilling once they get started, with everybody wanting to get a share of the action. As long as you’ve made your move in a timely fashion, however, this won’t reduce the profit you can make.

The most important thing to understand about forex is that it’s not a magical way of making money fast. If you want to be successful, then you’ll have to do the work and approach it diligently. If you apply yourself and really learn how it works, however, then you could do very well indeed.