Though veteran forex traders and the industry itself may suggest that trading foreign currencies is purely a high-brow activity, nothing could be further from the truth. A couple of trade examples are enough to fully equip even new traders with the basic mechanics of forex trading.
Currency Pairings
All forex trades are simply speculations, or bets, that one country's currency will increase or decrease relative to another nation's currency. For instance, if a trader felt the British Pound was going to increase in value relative to the Swiss Franc, that trader would 'buy' the British Pound/Swiss Franc combination offered by a vast network of forex brokers that essentially make the forex market.
Presently, there are about 80 different forex trade combinations possible. The Pound/Franc is one, the Euro/U.S. Dollar is another, and the Yen/Swedish Krona is a third. Yet, there are 77 more... enough to meet the trading needs of any forex market participant.
One oddity with foreign currency trading that is different than most other trading markets is that the forex combinations are static, meaning while there is a Euro/U.S. Dollar trading option available, the opposite U.S. Dollar/Euro combination does not exist. A trader who felt the U.S. Dollar was going to increase in value relative to the Euro would need to 'short' (or bet against) the Euro/U.S. Dollar pairing.... and buy it back later when the trade was closed.
While the idea of shorting may suggest infinite risk in the stock or equity market, for currency exchange, there is no more or less risk in shorting a trade than there is in buying a trade. Why? Technically speaking, buying the Euro/U.S. Dollar combination is the condensed way of saying 'buy 100,000 euros using U.S. dollars'. To take the opposite stance, shorting the Euro/U.S. Dollar pairing would simply mean 'buy U.S. dollars using the appropriate number of Euros'.)
Choosing Your Leverage
The only other mechanical difference between the stock market and forex market- usually- is the way in which forex trades are measured and monitored by the trader.
With stock trades, a finite number of shares at a finite price translate into a specific value (and a specific gain or loss) at any given time.
Currency trades also generate unrealized gains and losses at any given moment. Forex trades, however, are usually just quoted as the current exchange rate; the associated gain/loss (often in real dollars) is simply displayed, and based on a pre-determined amount of leverage the trader wishes to apply.
Depending on the account, a forex trader may only have a margin requirement of 1%, meaning he or she could place a $100,000 currency trade with only $1000 in the account. That translates into 100 to 1 leverage.
While greater leverage can mean greater returns on a relatively small amount of money, it can just as easily mean greater losses. Most currency speculators don't maximize their leverage choices, simply to limit risk. (Indeed, some brokers don't allow more than 80% leverage, and some may limit it to 50%.)
Example of a Forex Trade
Let's assume a currency trader felt the Swiss Franc was going to increase in value in relation to the Japanese Yen. With the currency exchange rate at 84.98, the trader would buy 100,000 Francs and pay for them with 8,498,000 Yen (though it's all handled with one simple transaction- the trader only has to place one trade).
And, let's also assume the trader only wanted to exercise 50% leverage to limit the risk of the trade. So, he commits 50,000 Francs worth of capital to the trade even though he only needed to put $1000 into it.
Later, if the Franc did increase as expected, say to a Franc/Yen exchange rate of 88.46, the trader would reverse the trade. However, now he would receive 8,846,000 Yen in return for his 100,000 Francs. That's a 4.0% return on the 100,000 Franc/Yen contract. However, this trader only put 50,000 Francs towards the trade. So, it was effectively an 8% gain on the amount of capital ever at risk.
Again, it should be noted that almost all forex trading platforms simply display the ongoing changes in the exchange rates, the dollar amount at risk, and a dollars gained/lost total for each trade. Currency traders no longer need to calculate the leverage and margin requirements for a particular forex trade. In fact, many forex brokers allow users to simply place a trade by clicking on a chart within a web-based interface.
Still, it's worth understanding.
Interested traders should know that may forex brokerage forms offers free practice accounts. These let traders learn and get a feel for forex trading without actually forcing them to risk any real dollars.
James Brumley - As a former stock broker and analyst, turned writer, James Brumley can tell you what most advisors can't - or won't. His belief is that ...
