Explanation of Currency Trading

Currency trading involves the exchange rates between different currencies.

The majority of currency trading is done by banks and international corporations. These companies need to convert earnings or revenues received in one currency into another. Investors also currency trade if they want to invest in the stock or bonds of another country where the rates are move attractive. Currency trading has also become popular with individual traders to profit from the relative price changes between currencies.

Function

Individual currency or forex traders set up an account with a currency broker or dealer to trade the different global currencies. Trading involves profiting from the changing value between two currencies. For example, if the euro gets more valuable against the U.S. dollar, traders can profit by buying euros and converting them back to dollars after the euro has risen. Forex dealers allow traders to profit from the moves without actually buying a whole bunch of euros.

Features

Currency trading is quoted in the value of currency pairs, such as EUR/USD for the euro and U.S. dollar pair. Popular currencies for trading are EUR, USD, CAD--Canadian dollar, GBP--British pound, JPY--Japanese yen, AUD--Australian dollar and CHF--Swiss franc. The exchange rate is listed as the cost of the first listed currency in the second currency. If the AUD/USD rates is $0.8400, the Australian dollar is worth 84 U.S. cents. Most currency pairs are quoted out to four decimal places or "pips".

Trading

Currency brokers allow traders to trade a large value of currency with a small margin deposit. The ratio between the margin requirement and the value of the trade is called leverage. Typical currency trading leverage is 100 to 1. This means a currency trader can trade $10,000 worth of a currency by depositing $100 or $100,000 with a $1,000 margin deposit. Currency traders count their profits and losses in "pips". For a $10,000 trade, each pip is worth $1.00, with $100,000, a pip's value is $10.00.

Considerations

Currency pairs are always listed in the same order. Euro vs. dollar trading is always EUR/USD. If the trader believes the euro will go up against the dollar he will buy the pair to open a trade. If he believes the dollar will get stronger he will sell the pair to start the trade. When a trade is opened, the forex dealer will restrict the margin amount in the trader's account. The trader then profits as the currency value moves in the correct direction. For example, if EUR/USD is at $1.2235 and the trader buys a $100,000 position, the margin required is $1,000 and the trader make $10 with each pip move upward. If the euro moves to $1.2245, the euro gained 10 pips and the trader made $100. Currencies often move 200 pips per day or more.

Costs

Currency brokers make money from the spread between the buy and sell prices of the currency pairs. Spreads are typically 3 to 10 pips, depending on the pair. In the example above, the trader would have really earned 7 pips if his broker has a 3 pip spread on the EUR/USD. Forex brokers like to promote heavy trading because lots of trades means lots of pips earned.

Misconceptions

There is no automatic currency trading system or strategy that will make a trader guaranteed profits. There is a large number of individuals and companies selling forex trading systems with promises of easy profits. According to the Commodities Futures Trading Commission--CFTC--there is a very large amount of fraud in the promotion of forex trading schemes.

References

• SEC: Foreign Currency Transactions
• CFTC: Consumer Advisory, Forex Fraud