Currency Trading 101
If you’re anything like me, you’ve only ever thought about exchange trading in the abstract, perhaps as you’re trying to exchange currency for a vacation. But there’s a lot that goes into currency trading, and a lot to be made if you understand it. Here are the basics of currency trading, in case you ever decide to get in on the multi-trillion dollar business.
Just what is currency trading?
Currency trading is, simply, the trading of currency for profit. The value of currency changes because of many different variables. If there is economic instability in a country, or if there is economic growth, the value of the country’s currency will rise and fall accordingly. If there is an increase in demand for a certain currency, its value can also rise. Many people try to anticipate when the value of a country’s currency will rise, and buy up its currency accordingly, similar to the stock market.
Currency is traded in the foreign exchange market, or Forex. The Forex market is the largest, most liquid market in the world. Liquidity refers to a market’s ability to sell an asset quickly and with no cut in price. In other words, something like your car or your house isn’t a very liquid asset. You may be able to sell them very quickly if you drop their prices, but in order to get the best price for those commodities, you have to wait for the right buyer.
The Forex market is liquid because currency is such a huge asset and is traded in such large values. There is always a demand for the currency being sold, and it can be sold instantly, often without having to lower its price. The average traded value of the foreign exchange market is $1.9 a day, and every currency is traded in the market.
Who does the trading? And how?
It used to be that only players with an immense amount of money could trade on the foreign exchange. That included large financial institutions, hedge funds, central banks, corporations, and very wealthy individuals. However, with the advent of the internet, the foreign exchange is open to everyone. Currencies are now traded with the click of a button.
The foreign exchange market does not have a central marketplace. Currencies are traded virtually, meaning no physical money is ever traded in a currency exchange. All trade is conducted via internet between traders around the world. This market is open 24 hours a day, 5 days a week (it’s closed on the weekends), with currencies being traded in the key financial centers of the world: New York, London, Paris, Hong Kong, Zurich, Singapore, Sydney, and Frankfurt. Because the Forex is open across all time zones, it can be extremely active at any time of the day.
Why do we trade?
The concept and practice of foreign exchange has been around as long as there have been world travelers. For us today, foreign exchange facilitates international travel and business. Say a business in the U.S. needs to buy merchandise from Japan. In order to pay for that merchandise, the U.S. would have to pay in Japanese yen. The Forex trade facilitates the currency conversion between the USD and the JPY, so the company in the U.S. can pay for the merchandise in yen, even though its income is in dollars.
Trading currency also allows people to speculate and make money based off the differences in interest rates of different foreign currencies.
Why is it such a big deal?
Because the foreign exchange is such a huge market, even the largest of players cannot control the prices on their own. This makes the Forex the most stable market in the world. There are also more high leverage opportunities in the foreign exchange market. Leverage is when you use borrowed capital to increase the potential of return on an investment. If you have a mortgage on your house, you’ve already experienced leverage.
In the Forex, leverage ratios can be as high as 250:1. That means if you had one dollar to trade, you could borrow up to $250 to invest. If you had a thousand dollars, the amount goes up to $250,000. You make money in trading foreign currency by correctly betting which currency will gain value relative to another. Currencies are traded in pairs on the foreign exchange, and you make money when the value of one currency decreases or the value of the other increases.
Let me give you an example. A quick google search tells me that currently the exchange rate between the USD and the EUR is 1 USD to .73 EUR. This means that one U.S. dollar isn’t even worth one euro. n fact, it would take 1.37 dollars to equal 1 euro. To make money on this pair, I would have to correctly bet that the U.S. dollar is going to increase in value at a certain point, or the euro were going to decrease in value, and then buy currency accordingly.
More info
There’s so much that goes into the foreign exchange market. If you’re seriously considering investing, I would check out Investopedia for more about the fundamentals of investing.
Mary Kremer writes content for Dinar Daddy, the number one source of information for trading the Iraqi dinar.
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Category: Forex
