If you have ever travelled to a foreign country, you may have needed to exchange your money for a different currency. If so, you have already participated in forex trading. “Forex” is the short form of for eign ex change. It can also be referred to as “FX” and currency exchange.
Forex trading in a nutshell
With all of the exchanging of currencies happening around the world, the exchange rates are constantly moving. Here is how it works:
Trading currencies is like exchanging money while on holiday
When currencies are exchanged, they have a certain price. the exchange rate. As with the price of anything, the price for a currency is determined by the laws of supply and demand.
If there is high demand for a particular currency – for example, many people or companies want to change their domestic currency for the euro – the value of the euro will then increase and the exchange rate will change against other currencies. You can use this principle to make money. To illustrate, let's use the example of going on holiday.
The value of a currency will increase if there is a higher demand for it, causing a change of its exchange rate against other currencies.
Say you live in Europe and go on a holiday to the United States. You will want to exchange euros for US dollars. At the time you do this, you get $1.40 for one euro. You exchange €500, therefore receiving $700.
After two weeks,
you head home, but you still have $250 left. As you have no use for dollars anymore, you change them back into euros.
You notice though, that the price of the euro against the dollar has changed – the exchange rate is now $1.30 for one euro, so you get approximately €190 back. Had the exchange rate stayed at $1.40, you would have only gotten €180 back. Therefore, you have actually made money.
Successful trading means using the exchange rate to make a profit
Here is an even clearer way of showing this principle using the same example:
As the exchange rate of a currency pair changes, so does the cost for purchasing one currency with another. For example, let's say you changed €500 and got back $700 while on holiday. If you come back and the exchange rate changed from $1.40 to $1.30, you would receive €538.5 for a €38.5 profit.
Let’s say that you changed your €500 into US dollars and got $700, but you did not spend any money at all and came back with $700. After the exchange rate changed from $1.40 to $1.30, instead of getting €500 back, you actually receive €538.5. You have gained €38.5 simply from holding your money in dollars while the exchange rate changed. This is essentially how we trade in the currency market. We buy a certain amount of a currency, hold onto it until the exchange rate fluctuates, then change it back once the exchange rate has fluctuated, making money in the process.