Forex trading involves buying and selling currencies. Just like we exchange physical money during a foreign vacation, forex trading involves buying one currency and selling another at the same time. The key difference is that forex trading is done specifically to generate profit from the exchange.
Understand forex activities
All forex trading involves two currencies. Because the prices of currencies on the open market fluctuate, for example due to supply and demand factors, investors will speculate that the value of one currency in relation to another will rise or fall. If a trader correctly predicts the direction of the market, he can make a profit. If not, he will incur a loss. Essentially, generating profit through currency trading is simply buying low and selling high or vice versa.
Generating profit in both directions is possible because, unlike traditional investing, forex trading does not involve buying or owning currency. Instead, traders only speculate on price movements using a derivative called a Contract for Difference (CFD). The main advantage of CFD trading is that traders can generate profit by speculating on a falling price, unlike stocks or physical assets where profit can only be made if the price rises above the purchase price.
How does Forex trading work?
Let’s look at a simple example to demonstrate how forex trading works:
Suppose you believe that the euro (EUR) will strengthen against the United States dollar (USD); in other words, you think that the value of the EUR against the USD will rise.
You open an online trading account and decide to buy 10,000 units of the EUR/USD currency pair at the current exchange rate of 1.1000. The total size of your CFD trading position will be:
€10,000 x 1.1000 = $11,000
Now that your trade is open, let’s assume that the EUR/USD exchange rate rises to 1.1200 and you decide to close your position. At this point, the difference between the opening and closing odds is 0.0200 (1.1200 – 1.1000). You sold 10,000 units, so the profit calculation is as follows:
€0.0200 x 10,000 = $200
As the value of the EUR has risen, you earn $200.
However, if the exchange rate were to move against your predictions, you would incur a loss. For example, if the price of the EUR fell from 1.1000 to 1.0900 (a difference of 0.0100), your loss would be calculated as follows:
0.0100 x 10,000 = $100
These examples show the difference that small price fluctuations can make, which is why when trading forex, it is important that we can afford to lose what we are risking.
Why trade forex?
The main reason for trading currency pairs in the forex market is the potential to generate profits.
Forex trading is a popular way to start investing with relatively little capital, which, when combined with leverage, allows you to gain exposure to higher-value trades. Additionally, because forex is traded using CFDs, traders do not have to worry about the costs associated with taking ownership of the underlying asset; FX trading consists only of real-time changes in the price of the underlying asset on the open market. Keep in mind that while leveraged trading offers the potential for higher profits, it can also amplify losses.
The 24-hour foreign exchange markets also offer great convenience and flexibility, allowing you to trade at different times of the day. This is especially beneficial for those who are employed full-time or part-time, as trades can be done outside of normal business hours.