The basic idea of forex trading is the same as any other investment -- you want to buy low and sell high. But in forex trading, you are using one currency to buy another, expecting that the currency you bought will increase in value compared to the one you sold. If it does, you will close your trade and sell at a profit. If you are wrong, you will have to sell at a lower price than you paid and experience a loss.
The principle is exactly the same as with more familiar investments, but the terminology is slightly different, and the math involved can sometimes be challenging for beginners. So before you're ready to trade currencies, there are a few forex basics you should know.
Getting a Handle on Forex
As we said, the basic idea of trading forex is that you're using one currency to buy another. Therefore, you'll always see currencies quoted in pairs, using a three-letter code such as EUR/USD (euro to U.S. dollar) or GBP/JPY (British pound to Japanese yen).
The first listed currency is the "base" currency, and the second one is referred to as the "counter" or "quote" currency. When you are buying, the quoted price tells you how much you have to pay in units of the quote currency to buy one unit of the base currency. For example, if you see EUR/USD = 1.4920, it means 1.4920 U.S. dollars will buy 1 euro.
You may notice that currencies are quoted out to four decimals points, compared to two points for stocks. In forex trading, all currency quotes are in a unit known as a "pip." This is short for "percentage in point," and is the smallest price change a currency pair can have. Since most currencies are quoted with four decimal places, a pip in forex is one ten-thousandth of a point. So if the EUR/USD exchange went from 1.4920 to 1.4925, it has moved five pips.
Now that you know the basics, how do you actually trade forex?
Just like trading a stock, you want to buy currencies that you think will rise in value relative to another and sell those you think will fall. So if you think the euro will rise in value relative to the U.S. dollar, you can buy euros, using U.S. dollars to fund your purchase.
Let's say you purchase 100,000 euros at the EUR/USD exchange rate of 1.5000 -- meaning it costs 1.5 U.S. dollars to purchase 1 euro. Now, assume that you are correct in your trade and in a week it takes $1.5200 to purchase 1 euro. In this trade, you spent $150,000 to buy the euros, and when you sold them, you received $152,000, for a profit of $2,000.
But what if you can't afford to buy 100,000 euros? This is where the advantage of leverage comes into play for forex trading. Since most moves between currencies are small, forex brokers allow investors to use leverage to magnify gains. Typical leverage amounts for retail investors are 100:1, or even 200:1.
Using leverage of 100:1, you would only need $1,500 to enter the trade above, and your profit would be still be $2,000 -- for a +133% return on your investment. Of course, using leverage adds risk, and your losses will also be amplified. That's why forex traders implement strict guidelines for exiting trades in order to protect their portfolio.
In short, forex trading represents another option for the well-educated investor. But with the potential for large swings in value thanks to leverage, it's important that forex traders have a firm grasp of how currency trading works before investing.