How Does Forex Trading Work?

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If you are on the internet lately (and you must be in order to be reading this article) then you have probably seen an advertisement for a popular form of trading called Forex trading. Before you jump on the bandwagon and open up a Forex trading account, let’s take a moment to explore a question plaguing many—How does Forex trading work?

What is Forex?
Every country has its own type of currency (although some share, like the countries that use the Euro). Each of these currencies has a value for trade when used within its originating country, but it can also be purchased using the currency of another country—like when you travel to another country and must purchase its currency with that of your own. And while a currency’s value might be fixed in terms of trading it for goods in its own country, it can vary when stacked up against the currencies of other countries.

For example, let’s say that you live in Canada and use three Canadian dollars to buy orange juice every day. If you want to trade those three Canadian dollars for U.S. dollars, you might get four U.S. dollars on Tuesday, but only three and a half on Wednesday if the Canadian dollar falls or the U.S. dollar rises. But no matter how many U.S. dollars you can get for your three Canadian dollars, you can always buy the same amount of juice in Canada—unless the store raises its prices.

Capitalizing on Value Variances
When people trade equities, they attempt to buy into the equity (or stock) at a low price. This means they buy 100 shares of XYZ stock for $X. Their goal is to hold their 100 shares of XYZ until it reaches a higher price and they can sell it for more than they bought it for. Forex traders have the same objective, but they want to buy and sell currencies instead of stocks.

For example, let’s say that the Euro can buy two U.S. dollars today. An investor might invest 100 Euros into buying 200 US dollars. As the U.S. dollar rises in value compared to other currencies, it will take more Euros to buy it, and the investor will get more Euros back when he sells his or her U.S. dollars than he spent to buy them.

Buying and Selling
When you take part in Forex trading, you will basically be buying and selling currencies. Each currency will have a bid price and an ask price. The bid price is the amount you can buy the currency for and the ask price is the amount you will likely be able to sell it for. The bid price on any given day will be higher than the ask price, and the spread—or difference between the two—is the amount that the bank takes for effectuating the sale.

Forex Risks
If you really want to understand how Forex trading works, then you need to understand the risks involved. First of all, currency prices can vary based on many different local and global economic factors and events. This makes it extremely hard to predict trends, which makes profitable Forex trading difficult for new investors. And while you may be able to expertly anticipate the movement of your own country’s currency, other countries may prove less easy to predict. In some instances, countries with fixed currency prices may decide to let their currency have a flexible and dynamic value (as China recently did) and its entry into the market can have unexpected results.

Secondly, many investors forget to diversify their Forex holdings, choosing instead to simply trade one country’s currency for another’s. Just as in stock trading, limiting your holdings to just one company or currency gives you little protection against downside risk and could expose you to loss that you can’t afford.

Third, many investors don’t understand how the fees and commissions add up with Forex trading. Fees and commissions eat into the amount you can afford to invest, and that can hurt an investor’s ability to profit. Comparing the spread, commission charges and account fees of various brokers is the best way to factor this in and ensure you get the most advantageous account.

As with any investment opportunity, Forex offers investors a great way to make a return on their investment, but it also offers many risks. Forex trading is not an automatic money maker and actually requires a certain sensibility in order to make it profitable.

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