The forex or currency trading market is the largest and fastest growing market on the planet. In April 2010 the forex market was estimated to have a daily turnover of 3.98 billion dollars, however a report released last month (July 2011) by Dow Jones Newswire and reported here by the Wall Street Journal estimates daily forex trading volume to have grown to 4.71 billion dollars. All of this trading in currencies is being carried out by central banks, commercial banks, hedge funds, institutional investors and private investors and speculators like you and me.
The forex marketplace is no different though from any other marketplace. It is a place where goods are bought and sold, in this case the goods being the currencies of various countries. Traders in forex are simply buying and selling currencies. Maybe they sell U.S. dollars to buy Yen or buy Euro with Australian dollars, but in the end it is simply trading one countries currency for another. And there is no need to actually physically hold the currencies so you can work with whatever your home currency is. For example, a U.S. based forex trader could open their forex account with U.S. dollars and then proceed to buy Euro to sell British Pounds.
In addition to the aforementioned huge trading base and liquidity, one of the chief advantages of trading currencies is the large leverage you are able to use with forex contracts. Leverage is the ratio of your investment to the actual value of the good, in this case a forex contract. It is very common to use a leverage ratio of 1:100 in forex which means for every $1000 you put up as margin you control currency with a value of $100,000. As you might imagine, this allows traders to make very large profits quickly when the currencies move in their favor. And the nice part is your greatest risk is only the $1000 you put up as margin on the contract.
In forex you can profit both when currency appreciates and when it’s value erodes. Unlike the stock market where stocks are (typically) only bought in hopes of appreciation in the forex market you can also sell a currency in the anticipation of it becoming weaker. The forex market in many currencies can fluctuate by as much as 1% daily, which may not seem like a lot, but when you consider that you are using leverage in your trading that 1% daily change could lead to profits of 100% daily! Of course this would be quite unusual, but it is possible, especially for currencies making a huge move, such as the chart of the Japanese Yen below from August 4th 2011.
As you can see the Yen went from a low of 76.919 to a high of 80.230 in less than 12 hours. That is a change of 3311 pips which would translate to a profit of $33,110 on a normal forex contract or $3311 on a mini-forex contract. And the Yen then proceeded to go right back down to it’s low over the next 6 days so the astute trader could have profited over $60,000 in one week trading just one forex contract. That’s the power of leverage and volatility in forex.
Of course the leverage and volatility do make forex risky to trade, but only if the trader does not have rules and discipline to protect his money. One such rule is never to risk more than you can lose. In fact, some traders (myself included) would caution that you never risk more than 3% of your account value. In addition, never add more money to a losing trade in the hopes that it will reverse and give you a profit. If you’ve lost on a trade let it go and learn from it. As long as you don’t chase your losers and follow the 3% rule you can never lose more than 3% of the value of your account on any one trade. And you stand to make much more if the currency trends in your favor.
If you feel that you might be suited to trade forex then you’ll need to find a forex broker. There are many brokers available and they are not all created equal. To learn more about the questions you should be asking before committing to a forex broker, which brokers offer the best terms and who I’m recommending check out my reviews of forex brokers.
