How FOREX Trading Works
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FOREX Structure
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A Forex transaction always consists of a currency pair, such as the euro and the U.S. dollar. Each currency pair has an exchange rate that's written in a standardized format. For example, EUR/USD = 1.3755 is the format for the euro/U.S. dollar pair and means that at the time this price was quoted it cost $1.3755 to buy one euro. The exchange rate can change by a very small amount (called a pip), which for the EUR/USD pair is 1/100 of a cent. Each currency pair has its own format, but they all follow this pattern. When a Forex trader wants to make a transaction, he goes to a currency dealer (usually called a broker) who executes the trade. Forex trading is largely unregulated, so experienced traders prefer to deal with a broker who belongs to a self-regulating organization like the National Futures Association.
Trading FOREX
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The Forex market, like other securities markets, negotiates prices using a bid/ask system. A seller states an asking price and a buyer makes a bid. For wholesalers (banks, governments, and large hedge funds) the "spread" between bid and ask is usually only 1 or 2 pips. Retail brokers mark the spread up 3 to 20 pips and keep the spread as their fee instead of charging a commission like stockbrokers. The Forex trader tries to anticipate which way the currency exchange rate will move and "goes long" if she thinks a currency's value will rise against another currency. He "goes short" if he thinks it will fall. When Forex traders guess right and the change exceeds the spread, they make money.
Margins
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What makes Forex trading so popular---and high-risk---is that trading is done with very low margin requirements. If you buy a stock on margin, FTC rules require you to put up 50 percent of the price of the stock. Forex trading works as it does because it isn't regulated, and it's common to have ratios of 30, 100, and up to 400 to 1. This means you can put down 1/400 of a standard lot of $100,000 worth of currency with as little as $250. The trader "borrows" the remainder from the broker. Usually this is for a very short time, since most Forex trades are settled within 24 hours and brokers usually don't charge interest.
Profit and Risk
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The low margin requirements make the pip very important. For a lot of $100,000 a change in the exchange rate of just 1 pip equals $10 and a change of 1 penny (100 pips) equals $1000. As a result, a Forex trader can make or lose a lot of money very quickly. For example, suppose you buy a $100,000 (USD) lot of euros with a 100: 1 margin. You put up $1000 and the spread is 10 pips ($100), which the broker keeps. If the euro goes up by 1/2 cent against the dollar overnight, you make $500 minus the spread, or $400 profit, a 40% gain in one day. But if the market goes the other way, and the euro loses 1/2 cent, you lose $500 plus the spread, for a total loss of $600.
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