Currencies

What is Foreign Exchange?

Foreign exchange, often referred to as forex, is the exchange of one country’s currency for the currency of another country. This exchange can be done for various reasons. Trade and international business often requires payments in currencies that are different for the buyers and sellers and in this case foreign exchange is necessary to make international trade work effectively. There are also those who like to speculate in foreign exchange, buying currencies in hopes they will appreciate in value relative to other currencies, thus netting the speculating trader a gain.

Popular Pairs

While every country has its own currency, the exchange of some currencies is far more popular than that of other currencies. This popularity stems from the demand for these currencies and because their liquidity makes them very trendy, with very tight spreads, or differences between buying and selling prices. There are seven major currency pairs that are considered as the most popular, both in terms of exchange for trade reasons and for speculation. Those pairs are:

• Euro/U.S. dollar (EUR/USD)
• U.S. dollar/Japanese Yen (USD/JPY)
• British Pound/U.S. dollar (GBP/USD)
• U.S. dollar/Swiss Franc (USD/CHF)
• Australian dollar/U.S. dollar (AUD/USD)
• U.S. dollar/Canadian dollar (USD/CAD)
• New Zealand dollar/U.S. dollar (NZD/USD)

Note that each of these pairs includes the U.S. dollar. That’s because the U.S. dollar represents the world’s largest economy and because it is the reserve currency of the world.

How do I trade in Currencies?

Trading CFDs in currencies is done through a broker. When trading currencies it is done in pairs, where the trader sells one currency in order to purchase another. For example, the USD/JPY pair contains the U.S. dollar and the Japanese Yen. In forex pairs the first currency is the base currency and the second is the quote currency. When you buy the USD/JPY you are actually selling U.S. dollars to buy Japanese Yen. When you buy any currency pair you are speculating that the value of the base currency will increase relative to the value of the quote currency. Perhaps an example can help explain this better.

Trading Example

Let’s say that the USD/JPY is being quoted at 105.40 and you believe that the value of the U.S. dollar will rise relative to the Japanese Yen. You place an order to buy 1 lot of USD/JPY. There are two potential outcomes.

You are right and the U.S. dollar does appreciate relative to the Yen. In this case the USD/JPY exchange rate rises to 107.20. You sell 1 lot of USD/JPY to close your position and you collect the 180 pips difference from when you purchased the lot. The value of a pip in this pair can fluctuate slightly, but for this example we will say that 1 pip is equal to 1 dollar. In this case you just made $180 on your trade.

The other outcome is that you are wrong and the exchange rate for the USD/JPY falls to 103.60. In this case when you sell a lot of USD/JPY to close your position, you have a loss of 180 pips or $180.

That’s a very simple example because it doesn’t take into account the spread when buying and selling, nor does it account for the leverage that can be used when trading forex.

What are the Benefits?

Trading in any financial market is difficult and many beginners and experienced traders lose money when trading the markets. The currency markets are no different, but the lure of earnings from trading keeps people coming back.

There are a number of benefits to trading currencies that keeps traders coming back to the markets. Of course, the possibility of increasing their capital is one of them, but it’s not the only one because that could be accomplished by trading any financial asset. Another, is the liquidity in the forex markets that means the cost of trading remains low and the ability to buy and sell is always a feature.

Another advantage to trading in the forex market is the ability to use margin to create leverage. This means a trader is able to put up just a small fraction of the total value of the trade, with the broker covering the rest. In some cases, it’s possible to invest just 0.2% of the value of the trade, which increases the potential gains and losses 400-fold. That means where a 1 pip move would usually be worth just $1, when using 400:1 leverage a 1 pip move becomes worth $400. You can imagine the ramifications.

Disadvantages of Currencies Trading

Just as leverage increases the potential gains in any forex trade, it also increases the potential losses. This makes leverage a double-edged sword and both a benefit and a disadvantage when leverage is not used properly.

Another disadvantage, often not considered by aspiring forex traders is the amount of research and knowledge required to successfully predict currency movements. The forex markets are very complex and it isn’t unusual for traders to get caught by geo-political risks they hadn’t considered.