What Is Forex Trading and How Does It Work?

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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.

Find Out: Do You Know the Differences Between the Stock Exchanges?
Learn: What Is Unrealized Gain or Loss and Is It Taxed?

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 $6.6 trillion, according to the 2019 Triennial Central Bank Survey of FX and OTC derivatives markets. The New York Stock Exchange, on the other hand, trades an average daily volume of just over $1.1 trillion. 

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Related: The Best Robo-Advisors

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.

Check Out: Understanding Interest Rates — How They Affect You and the US Market 

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.

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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.

Read More: What Does the Fed Do, Anyway?

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.

    About the Author

    After earning a B.A. in English with a Specialization in Business from UCLA, John Csiszar worked in the financial services industry as a registered representative for 18 years. Along the way, Csiszar earned both Certified Financial Planner and Registered Investment Adviser designations, in addition to being licensed as a life agent, while working for both a major Wall Street wirehouse and for his own investment advisory firm. During his time as an advisor, Csiszar managed over $100 million in client assets while providing individualized investment plans for hundreds of clients.

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