In this text we will look at the basics of currency trading. Currency trading or forex trading may seem complicated at first glance, but the currency trading basics are not that difficult to understand. Currency trading is simply the act of exchanging one currency for another on the currency market. Every time a family changes money to go on vacation or a company makes a foreign purchase, a transaction on the forex market is carried out. The currency market exists only when a transaction is made. Unlike other financial markets such as the stock or bond market, there is no forex exchange and neither any regulating body. The market that is commonly referred to as the currency market is the banks internal market called the Interbank market. Because of this, it has traditionally been difficult to trade forex for money, but this all changed when the internet brought unlimited possibilities to connect traders to the exciting world of forex trading.
Currency Trading Basics
Let’s look at how currencies are traded. All currencies have a floating price, as you can’t trade a currency by itself, you must always either buy or sell another currency as well. This is why currencies are traded in pairs of two currencies such as the USD/JPY or USD/EUR. There are many currencies in the world, but only a few are traded and used globally. For forex traders, these are the main currency pairs of interest as they hold the largest liquidity and the biggest opportunity for profit. The major currency pairs are:
USD/EUR, USD/JPY, GBP/USD, USD/CHF, EUR/CHF
These pairs put together account for more than 85% of all forex transactions, so it is very reasonable to focus on one or more of them as a forex trader. There are of course also less traded pairs called ‘exotic pairs’ and while they are a lot less liquid, they do hold opportunity for profit if you know what you’re doing.
When a forex trade is carried out, two things happen: One currency is bough and one is sold. If you believe that one currency will appreciate in value, for example the USD, then you buy that currency with another currency, this could be EUR. If the USD then goes up in value against the EUR, you can change your USD back into EUR and get more EUR than you initially had. This is how profits are made. Let’s assume you bought 10 USD for 10 EUR, not the real rate but used to keep things simple. What has happened is that you have sold EUR and bought USD. If the relative worth of USD increases to 15 EUR. You can then sell your USD and buy EUR back and since you only paid 10 EUR to begin with, you have now made a profit of 5 EUR. This mechanism becomes extra powerful when you combine it with leverage, which is gearing your investments with loaned money. In forex, it’s common to leverage your trades up 100 times. That means you can trade for $100,000 with only a $1000 deposit. This unique option for leverage is a huge reason for the popularity of forex trading.