Forex Trading Basics: Getting Started

Generate Trading Profits With Foreign Currency Exchange

Aug 31, 2009

The foreign currency exchange market - or 'forex' - is one of the simplest yet most dangerous ways to trade for income. Here are the basics all traders need to know.

Even though ownership in stocks and the trading of futures and options has skyrocketed in recent years, the foreign exchange market- also called forex- is still by far the most liquid and most universal trading market. Why? It's simple, transparent, and can potentially produce greater returns than any other financial arena.

The flipside, of course, is risk... one of the most recognized aspects of forex trading. Yet, if managed properly, the bulk of the risk associated with foreign currency trading can be abated.

The following is a brief but complete primer for traders interested in getting started in forex.

Why Forex?

The first reason is simply that currency exchange pricing- even its fluctuations- is straightforward. Unlike stocks or options that may or may not move consistently or rationally, the exchange rates between two are either rising or falling. There may well be an underlying reason for a currency trend, but there is no 'psychology' to the trade. Forex traders buy on the way up, or sell on the way down.

The second reason forex is preferred by many is the massive leverage it can offer. Depending on the type of account established, by using margin a trader can magnify a currency price fluctuation by as much as 500 times. In other words, a one percent move in an exchange rate can yield a 500% return on the amount of capital risked on a trade.

How to Trade Forex

The process for entering a currency trade is really quite simple; traders buy (or sell) a certain 'pair' of currencies. There are dozens of combinations. For instance, a trader who believes the U.S. dollar is going to rise in comparison to the Euro would 'buy' the USD/EUR pair. When that trader feels the dollar has reached its maximum potential versus the Euro, he or she will sell the USD/EUR to close out the position.

Most forex trading platforms offer 'one click' trading. This simply means all the popular currency exchanges are arranged- visually- on a computer screen. All the trader would need to do is click the buy or sell button for any currency exchange combination.

Forex Trade Example

Assume that a trader feels the Swiss Franc is going to depreciate in relation to the Japanese Yen. For hypothetical purposes, assume that the current exchange rate is priced at 87.76. In this case, it would mean 1 franc is worth 87.76 yen.

Since that particular pair is quoted as CHF/JPY, the trader would sell (yes, it is possible to sell first, then buy a pair back later) CHF/JPY to open a position.

If the same trader felt that CHF/JPY would fall to no less than 86.50, he or she would buy that forex pair back when that 86.50 rate was hit. The net movement would only be 1.43%, which isn't much for a stock trade, but is a substantial gain for a forex trade.

Leverage & Risk of Forex Trading

Sticking with the CHF/JPY example, that 1.43% move - depending on the account's settings - could actually turn into a gain of anywhere from 286% to 715%... but only on the amount of capital traded.

It would be very unwise to risk a significant amount of capital on any single trade though; the triple-digit gain is not a gain for the entire account unless that trader risked 100% of the account's value. Generally speaking, forex traders will only allocate 5% to 10% of an account's value to any singly trade. Moreover, even a 1.4% move for any currency pair is an unusually large gain.

Even more important to recognize is that had the CHF/JPY exchange rate moved in the other direction by the same 1.4%, the gains of 286% to 715% would have instead turned into losses of the same size. Therefore, it's crucial that foreign currency traders cut loose of losing trades quickly and consistently.

Where to Trade Forex

Forex trades can only be placed in currency trading accounts, through a currency trading broker. Some online stock brokerage firms offer forex accounts as part of a regular brokerage account, but those services tend to pale in comparison to a forex-specific platform. A good forex broker will offer assistance or accessible tutorials on how to get the most out of their trading platform.

The account minimums vary, but most forex brokers will open a trading account funded with only a few hundred dollars.