Forex trading is the act of pairing currencies against each other, and making money based on the fluctuating rates. If you've travelled abroad and exchanged a few of your bills with a bank or Forex stall, then you've participated in a currency trade.
Like investing and trading the shares of a stock, the principle of Forex is buying currencies when they're low, and then selling them when they're high. Forex prices are extremely volatile, and can change several times in a minute. This volatility is what Forex traders take advantage of. Without the fluctuations in prices, there can be no Forex trading.
Not all currencies, however, are being traded on the Forex market. There are only 8 currencies to pair against each other, and these are AUD, USD, EUR, JPY, GBP, CHF, CND, and NZD. These currencies have enough volatility for traders to take advantage of.
How do traders make money by trading Forex?
In order to trade on the market, you must first choose a currency pair. For this case, let's use the AUD/USD pairing. At the time of this article, AUD 1 = USD 0.77. This means for every Australian dollar that a trader has, he or she can purchase USD at a 0.77 value. Now, after 10 seconds, let's say that the price changed, and now AUD 1 = USD 0.79. When this happens, traders can sell their USD and earn 0.02. This example doesn't show Forex's high chances of profitability but imagine the transaction on a bigger scale. If the trader sold USD 10,000 for a profit of 0.2 each, then he or she would've made USD 200 in just 10 seconds.
Apart from trading currencies using their spot prices, traders take advantage of leveraging. FXCM suggests that the liquidity on the Forex market is so deep-- around USD 5 trillion (AUD 6.50 trillion) a day -- that banks allow people to trade with leverage. Basically, leveraging is a loan that is provided to investors by Forex brokers who handle their account. To ensure they have leverage, traders need to open a margin account with their broker. The amount of leverage is usually 50:1, 100:1 or 200:1. The margin account that will be granted to a trader depends on the size of their capital. A 50:1 leverage is the minimum margin requirement, while a 200:1 is the maximum. If you're trading 200:1, you can trade AUD 2,000 on the market while only using a $10 margin in your account. This gives you more exposure to different currency pairs while keeping your capital to a minimum.
Important thing to remember about leveraging
While traders are allowed to have leverage on their trades and therefore increase their profit potential, experts advise using this tactic sparingly. That's because while leverage can augment your revenues, it can also double or triple your losses. Leverage increases your financial risk, and you can. If you're new to Forex, you should always begin by trading with lower ratios until you get the hang of reading past price charts, and recognizing economic events that affect currency prices.
If you want to set yourself on the road to becoming a veteran trader, you should start learning how to trade using a Forex dummy account. There are sites that provide free dummy accounts for Forex trading that you can take advantage of. Some even include tips on how to read price trends, as well as fundamental factors that affect the movements of currency prices.