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What is Forex trading and how can you profit from it?

  • 11/09/2017
  • Alpari
What is forex trading

Forex trading might seem to be a recent phenomenon, but it’s something that we, as humans, have been doing for a very long time. What makes humans different from other species is our ability to collaborate with each other and trade goods and services, which has helped us create groups, villages, and nations in the process. People have been trading their valuables in exchange for something they need since the dawn of time. The core concept behind Foreign Exchange or Forex trading is very similar.

As you may already know, different countries have different national currencies. The United States, for example, has the US dollar, the United Kingdom has the British pound, and South Africa uses the South African rand. If you have ever traveled outside your home country, the chances are that you needed to exchange your national currency for the currency of the country you were visiting. If you have done so, then you have already traded Forex without even knowing!

However, while trading Foreign Exchange at the airport on the way to your dream destination technically counts as Forex trading, the reality of trading Forex to make a profit is a whole other ball game. Today, becoming a Forex trader means participating in a global market that trades over 5 trillion dollars a day. While traditionally, the Forex market was only accessible to big banks in the past, with the advent of the Internet, today, anyone can start trading Forex.

What it means to trade Forex for profit

While money changers have existed since the invention of money, the modern era of Forex trading is a relatively new thing in history. You see, after World War II, the United States and its allies wanted to start a global effort to rebuild the war-ravaged economies of the world and to do so, they needed a global agreement to cooperate with each other to facilitate international business. Hence, to create a unified financial order in the postwar world, all the major economic powers attended a meeting formally known as the United Nations Monetary and Financial Conference, or the Bretton Woods Conference, in 1944. At that conference, it was agreed that each nation would pursue a monetary policy that would tie their national currencies to the price of gold.

Since the price of every national currency on earth was tied to that of gold, there were virtually no price discrepancies between any currencies. The only way the price of a currency could go up or down was when the price of gold fluctuated. The Bretton Woods system kept the currencies from having wild fluctuations and made it easier for countries to trade in the aftermath of a devastating World War.

However, in 1971, the United States officially ended the Bretton Woods system when they stopped using the gold standard, effectively making their currency a free float. Soon, all the major countries with large economies also disavowed the historic Bretton Woods system and as a result, almost all national fiat currencies of the world today are considered to be free float currencies.

What this means is that instead of being tied to the price of gold, the exchange rate between two fiat currencies is determined by the supply and demand of the respective currencies. Hence, the US dollar could lose its value against the British pound, while at the same time, its exchange rate could go up against the Japanese yen.

As a result, since the early 1970’s, currency rates often experience significant daily fluctuations. The free float nature of fiat currencies enabled investors to anticipate which currency’s rate is likely to go up or down against other major currencies and make a profit from the difference in prices.

In the modern world, when someone speculates on the future price movements of a currency and exchanges one currency for another with the sole purpose of profiting from price movements, they are engaging in Forex trading.

How to read currency rates

What is forex trading

Before we start discussing how you can make a profit from trading Forex, you need to learn to read currency rates like a professional trader. You have probably seen a currency rate board at your local money changer and thought that it doesn’t seem complicated at all. However, when you want to trade currencies for a living, you need to read the rates like a professional trader, as well as learn the lingo of the industry.

You see, Forex rates are identified with currency symbols that represent two fiat currencies. For example, the symbol EURUSD means how much 1 euro is worth against the US dollar. Here, the first currency in the pair is known as the base currency. The second currency of the pair is called the quote currency. So, when you see the rate EURUSD 1.1600, it means that 1 euro is currently worth 1.16 US dollars. If the value of euro (the base currency) goes down against the US dollar, the EURUSD rate will also go down. Conversely, if the value of the euro goes up against the US dollar, the EURUSD rate will go up.

Most currency pairs are quoted with up to four decimal points with the exception of pairs involving the Japanese yen, which are usually quoted with up to two decimal points. Hence, you’ll often see that the EURUSD rate is displayed as 1.1625 or 1.1836, but the USDJPY and GBPJPY rates are shown as 102.50 and 145.68 respectively.

How to make a profit from Forex trading

What is forex trading

As we discussed above, you can benefit from Forex trading through price fluctuations. For example, if you buy EURUSD at 1.1445, and the rate goes up to 1.1845 within a week or two, you can sell your position with a net profit of 0.0400 points or 400 pips. One of the most significant aspects of Forex trading is that you can not only buy low and sell high, but you can also sell the currency pair at a higher price and repurchase it at a lower price to make a handsome profit. This reverse process is known as short selling.

Aside from buying and selling currencies, you can also trade Forex to hedge your investments in a foreign country. For example, if you want to invest in a company trading on the New York stock exchange from Nigeria, which requires you to convert your Nigerian naira into US dollars, then you can sell an equal amount of USD (by buying NGNUSD) to hedge your investments. By doing so, if the US dollar loses value against the Nigerian naira, your profits gained from investing in the US company would remain the same! In fact, a significant amount of daily trading volume in the global Forex market comes from large-scale international companies hedging their foreign investments.

There is another way you can earn a profit from Forex trading, which is known as a “carry trade.” You see, when you buy a currency, you are also entitled to the interest rate offered by its central bank. So, if you purchase a currency that offers a higher interest rate, and sell a currency that offers a lower interest rate, you can quickly earn a profit from the interest rate difference! For example, as of the 3rd of September, 2017, the US Federal Reserve currently offers an interest rate of 1.25%, while the Bank of Canada offers an interest rate of only 0.75%. Hence, if you buy the USDCAD pair, your Forex broker will pay you a daily overnight interest difference called a swap rate for as long as you keep your position open.

While we’ve mentioned a few strategies, there are many different ways you can make a profit from trading Forex, and you should invest some time into learning about different strategies to become a good trader.

Leverage makes Forex trading a lucrative business

Since day-to-day currency rate fluctuations are often minimal, you need to make a significant number of transactions at a time to make enough profit. However, professional Forex traders get around this problem by using leverage. Leverage is a like a short-term loan from your brokerage firm, which gives you a line of credit to buy or sell assets in the market against your deposit. For example, most regulated Forex brokers offer 100:1 to 200:1 leverage to their customers, while unregulated brokers can offer as high as 800:1 leverage on certain high-value accounts. What it means is that once you make an initial deposit of just 1,000 USD with your broker, you can buy or sell up to 100,000 USD worth of currency and magnify your profits accordingly. However, keep in mind that if you are not careful with using leverage, it can cut both ways and you can also lose a lot of money very quickly.

How can you start trading Forex?

Not so long ago, if you wanted to trade Forex, the only way was to invest in a hedge fund, which required investors to commit an insane amount of money to begin with. In fact, the barrier to entry into the Forex trading arena was so high that only large banks with international operations and institutional investors with global business interests were participating in the Forex market. However, with the advent of the Internet, it has become much easier to start trading Forex in recent years.

During the last twenty years, a lot of Internet-based Forex brokerage firms have begun offering their services to customers, and they often require a very reasonable initial investment. Besides, since most of these Forex brokers are offering their services via the Internet, you can trade Forex from virtually anywhere, as long as you have a stable Internet connection.

Also, the Internet has made it possible for brokers to offer their services globally. It means that if you are considering trading Forex from Nigeria, you do not have to stick to a local broker. You can do research on any international Forex brokerage company that offers their services to Nigerian Forex traders, such as Alpari.

Reputable brokers like Alpari, among others, offer state-of-the-art platforms like MetaTrader 4 as well as other trading tools. Once you install this trading software, it gives you the instruments you need to conduct technical analysis. Most trading software also includes a live news feed that provides the latest updates on the global economy, which enables you to do fundamental analysis on the currency pair you are interested in.

Aside from providing tools and transmitting your orders to the interbank markets through partner banks and liquidity providers, most Forex brokers also offer a free demo account. With a demo account, you can trade Forex without taking any risks, which will help you improve your trading skills. Therefore, it is recommended that you invest money in a live account only after you have started making a consistent profit and feel confident about your abilities to predict price movements.

Conclusion

Forex trading has become popular in the last few years because it offers anyone with the desire to learn this business the opportunity to make some passive income on the side.

Now that you know what Forex trading is and have a basic idea of how you can trade to earn a profit, you are probably wondering if this is the right business for you. While it is only you that can know the answer for sure, keep in mind that anyone with some free time and a small amount of capital can venture into the world of Forex and start making some income on the side.

However, please note that trading Forex carries a high level of risk due to the use of leverage and you should only invest money that you can afford to risk. Moreover, learning how to place an order with your broker and knowing how to make a consistent profit from trading Forex are two very different things. To become a successful Forex trader, you need to invest some time to learn about various trading strategies, risk management techniques, and to prepare yourself psychologically. However, do not worry, because there are plenty of free educational resources available online that you can use to learn about this business.

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