Forex trading means making money by buying and selling different currencies. In simple language, the purpose of traders is to exchange one currency for another with the expectation that the exchange rate will be favorable. It is a fact that Foreign currency exchange (Forex) is the largest financial market in the world and is worth trillions of dollars in volume traded daily. But how do forex traders make money? So let’s explain it in more detail.
What Is Forex Trading?
Forex trading means selling one currency and buying another one, simultaneously. Amongst other procedures, currencies are traded in pairs such as EUR/USD (Euro to United States Dollar) or GBP/JPY (British Pound Yen). So basically trading currencies starts with there expectation to make a bet on whether or not the value of a currency toward another one will rise.
Currency Trading Basics For Beginners
Trading of currencies never takes place without pairs, hence, in every forex trade, one currency has to be bought and another sold. The first currency in the pair is known as the base currency while the second one is called the quote currency. For instance, using the EUR/USD pair, the Euro is the first currency while the United States Dollar is the second.
When purchasing a currency pair, it can be said that you are acquiring the base currency while at the same time selling the quote currency. In the case of a currency pair being sold, the opposite, in this case, sells the base currency and buys the quote currency.
How do Exchange Rates Work?
An exchange rate indicates the amount of the quoted currency that is needed to acquire one unit of the base currency. For example, the EUR/USD exchange rate is at 1.20; meaning one would need 1.20 US Dollars to be able to buy one Euro. There are many reasons that explain why exchange rates are volatile, these include economic, political, and market influences.
How can Forex Traders Earn Money?
Speculating on foreign currency price movement or prediction of price change in currency pairs have come up with the use of currency price changing its value or price towards other currencies. This means if given the chance to forecast the future value or prices of the base or quoted currency, one may earn profit. For example, if a trader believes that a pair currency consists of the base currency, it will be better for them to buy it.
Forex Trade Example:
Suppose you have a reason to believe that looking at the Euro it is going to appreciate against the US dollar, e.g. The US is underperforming relative to other economies around the world. You purchase Euros for 20,000 Euros at an exchange rate of 1.20 EUR/USD. This basically means that you bought $12,600 in Euros (10,000 x 1.20). Now a week goes by and the exchange rate is 1.25 and you sold your ten thousand Euro back for 12% profit. You earned 500 dollars as a profit.
This is a basic illustration, but nevertheless, it explains how forex traders make a profit by buying for less and selling for more.
The Bid, Ask, and Spread: How They Work
In the forex market, prices are interlinked and two prices will always have a corresponding price: the ask price (which is always higher) and the bid price. The bid price lets one sell the base currency while the ask price lets one buy the base currency. There is what is called the spread: the distance between the buying price and the selling price.
What Impact Can the Spread Have Over the Cost of Your Trade?
The spread represents the expense associated with foreign exchanges. For instance, if one were to assist in setting the selling price of EUR/USD at 1.3456, and the purchasing price at 1.3458, it is very easy to measure the spread as 0.0002 (or 2 pips). The price of commodities must surpass the expense of spread with favorable market fluctuation to generate a profit. Where the gap is far too large, it tends to have a negative bearing on the profitability potential of day traders.
Pro Tip: Always compare various forex brokers and choose the ones who have reserved the small gaps in prices, which reduces your trading costs and converts into higher profits for you.
Going Long vs. Going Short
In forex trading, making a profit does not correlate to whether the market is up or down. As one can either go long or short to make a profit, this is why;
Going Long
First let’s start in specifics, if you decide to buy a currency or to go long, it literally means buying the base currency and selling the quote currency. It is basically the conviction that the base currency will appreciate in the future. If the prediction comes true, you purchase it with an intention of selling it at a higher price which creates profit.
As an example, if the buying price of Euro USD reaches 1.20 and goes to 1.25, the seller can sell off the euros making a 0.05 profit.
Going Short
In short, you are basically selling the base currency and buying the quote currency. This happens principally when the person believes that a currency will drop in price in regard to their trading position. If that happens, then one will sell it at a future time when the price has dropped below that value and gain a profit.
For instance, if 1.25 is the current selling price for a Euro-USD currency pair, the seller expects that the price of that currency pair will drop to 1.20 shortly. If the price reaches as low as 1.20, one would buy back at the lower price and make a gain of 0.05 per euro.
Pro Tip: To minimize the risk, the trading plan should be drawn before entering such trades. Price target and stop-loss level will assist s in minimizing the risk.
The Importance of Leverage in Forex Trading
Leverage is one of the most distinguishing characteristics of forex trading. It lets you control a large position, for just a fraction of its value. Let’s say that your broker uses a leverage of 100:1 which means that you can control a hundred thousand dollars with just one thousand of your capital.
Leverage: Not so easy does it sound?
Leverage provides you with the power of more gains, however it also offers the risk of more losses. For instance, you have $ 1, 000 in your account, and considering a leverage of 100:1 you can now control $ 100, 000. A market move in your favor of 1 % would yield a profit of $ 1, 000 for you but a 1 % move in the other direction would mean a loss of the same amount which leaves you with a zero account balance.
Pro Tip: Don’t use leverage above your control. This would put your account balance at risk. Always use stop losses to protect your account balance from being wiped out.
The Economics of Currency Trading
Other factors include economic data, political events, and market sentiment which are also some of the other factors that influence currency prices. Making sense of price action through these factors will assist you in making trades.
Economic Data
Certain economic statistics like GDP growth, inflation, employment statistics, and interest rates can greatly determine the performance of currencies. For instance, if a country’s economy is performing above expectations, its currency will appreciate.
Political Events
Currency prices are also influenced by political events such as elections, governmental policy, and geo-political strife and confrontations. For instance, instability concerning the future political scenario of a certain country will discourage investors therefore the currency of that country will depreciate.
Market Sentiment
The overall outlook for a currency pair and the sentiment of the traders in regard to price movements is known as market sentiment. Traders with a positive outlook on the economy will purchase currencies that will increase their prices. However, if the outlook is negative, the asset will be sold, lowering the price.
Pro Tip: One of the most commonly disregarded aspects of trading is keeping up with economic calendars and news events. Knowing of future events lets traders prepare for the market and trade accordingly.
The Role of Forex Brokers
Forex brokers are an integral part of the entire trading process. They run the trading platforms, and provide the leverage and the spread. You will need the right broker if you wish to be a successful forex trader.
Factors to Consider When Choosing a Forex Broker
When you decide to broker forex, pay attention to the following considerations.
- Regulation: Check if the broker is licensed by any regulatory agency.
- Spreads: Seek out brokers with tight spreads in order to save on costs when trading.
- Leverage: Verify the leverage levels that the broker provides.
- Customer Service: Confirm that the broker has dependable customer support that can assist you when required.
- Trading Platform: You should be able to navigate the platform with ease and have access to the trading tools that you require.
Pro Tip: Make sure you open a demo account with the broker and use it before risking any real funds, to try their platform and services.
Forex Trading Risks
Forex trading can yield positive returns, but it is accompanied by risks. These risks if understood can help the trader manage his capital and make better trading choices.
Market Risk
Market risk is defined as the risk of loss that exists because of market movements that are not favorable. This risk is ever present in the forex market because news and events can change the price dramatically in a short period of time.
Leverage Risk
This risk is associated with how effective leverage works to increase profitability. Leverage works effectively to enhance profitability and losses, and too much leverage can cause great losses that may result in even account destruction.
Liquidity Risk
Liquidity risk is the risk that you will not be able to exit a particular trade at a price that you would like to exit a particular trade as a result of an absence of sellers or buyers in the market. This can happen due to several factors including thin trading, or the occurrence of some news.
Pro Tip: Reduce your risk by placing stop-loss orders and using a reasonable amount of leverage. Do not allow yourself to risk more than a small fraction of your total account on one trade.
How to Start Forex Trading
In case you are wondering how forex trading works, below are the stages to follow;
1. Select a Reliable Broker
A broker is simply an intermediary through which you can trade currencies. Choose a broker who has a simple trading platform, low trading volumes, and great customer care. Get a broker who is licensed by a regulatory body to mitigate any loss of your investment.
2. Create a Trading Account
After selecting a broker, the next step is to open a trading account. You may wish to create a demo account first in order to learn how to trade without the risk of incurring any losses. Once you feel confident, you may convert to a live account and begin trading for real.
3. Fund Your Account
In order to trade, you have to travel to your trading account and deposit money in it. Most brokers allow up to 3 payment methods, such as wire deposits, credit cards, or e-wallets.
4. Educate Yourself
Take a step back and learn about foreign exchange trading before you begin trading. There are quite several web-based platforms such as articles, videos, and webinars to which you do not have to pay. However, it is imperative to learn how the foreign exchange market works, how to analyze charts, and the application of technical indicators.
5. Create a Trading Plan
You can consider a trading plan as a map of your trading journey. It describes your objectives, risk levels, and strategies for trading. This way a trader has clear guidelines and is less inclined to make erratic trades.
Summing Up
Forex trading has its earnings potential, though it is not devoid of risks. This would include understanding how forex traders usually earn money, how crucial risk management is, and the protocols that a trader needs to follow to decide if forex trading is suitable for them.
We must always remember that trading is a skill that takes time to master, and in fact, it is a never-ending journey. All traders should begin with small investments and prioritize sound risk management practices while focusing on continuous learning. New and experienced forex traders alike will find that these rules will help make them successful in their quest as forex traders.
