What Is Forex Trading and How Does It Work?

You can profit from exchange rate changes between currencies.

In addition to stock and bond market information, the nightly financial news usually offers information about the currency exchange rate between the U.S. dollar and various foreign currencies, such as the euro and the British pound. This information isn’t important just to tourists heading overseas. Foreign exchange traders try to profit on movements in the market price between foreign currencies. Trading on the foreign exchange market can generate tremendous profits but can also carry significant risk. Here’s a look at the ins and outs of forex trading.

What Is Forex Trading?

Every day, foreign currencies go up and down in value relative to one another. As with anything that changes value, traders can profit from these movements. The forex market runs 24 hours a day, making it a very liquid market. What surprises many investors is the size of the forex market, which is actually the largest financial market on Earth. The average daily traded volume is more than $3.2 trillion, according to XE, a foreign exchange company. The New York Stock Exchange, on the other hand, trades an average daily volume of just $55 billion. The trading volume of all of the equity and futures markets in the world combined would only be one-quarter of the size of the forex market.

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How Forex Trading Works

Forex trading is similar to buying and selling other types of securities, like stocks. The main difference is that forex trading is done in pairs, such as EUR/USD (euro/U.S. dollar) or JPY/GBP (Japanese yen/British pound). When you make a forex trade, you sell one currency and buy another. You profit if the currency you buy moves up against the currency you sold.

For example, let’s say the exchange rate between the euro and the U.S. dollar is 1.40 to 1. If you buy 1,000 euros, you would pay $1,400 U.S. dollars. If the currency rate later moves to 1.50 to 1, you can sell those euros for $1,500, generating a profit of $100.

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Effects of Leverage

Leverage is commonly used in the forex trading market. Leverage allows traders to purchase a multiple of their original investments. For example, some forex traders will employ leverage of 20:1. This means they can buy $20,000 of foreign currencies for just $1,000, with the brokerage firm lending them the remaining funds. Some firms might allow leverage of up to 500:1.

Leverage in any investment, including the forex market, amplifies both gains and losses. For example, if you buy $20,000 in currency and it moves up 10 percent, you’ll have a $2,000 gain. If you used 20:1 leverage and only invested $1,000, that amounts to a 200 percent gain.

Of course, leverage works both ways. Using the same 20:1 leverage example, if your $20,000 moved down 10 percent, to $18,000, you’d not only lose your entire $1,000 investment, but you’d also have to pay off your loan to the brokerage firm.

Learn More: How to Trade Forex — A Step-by-Step Guide

The foreign exchange market offers the potential to profit off moves in the forex rate. Through the use of leverage, moves in currency markets can be amplified. Forex trading is often best left to speculators and professional traders.

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