How Forex Traders Make Profits
Currencies trade in pairs. For example, EUR/USD means the euro-U.S. dollar pair. The second currency is quoted in terms of the first, or base, currency. EUR/USD 1.2500 means one euro will buy $1.25 U.S. dollars. When a trader thinks the base currency will go up relative to the second currency, he “goes long” by taking a buy position. If he thinks the dollar will get stronger, he takes a sell position in the base currency. Suppose he goes long with the euro at $1.25 and the exchange rate rises to $1.30. The trader makes a profit because he gets back $1.30 for every $1.25 of currency he bought to start with.
Understanding Forex Trading Risk
Currency is traded on margin. For instance, a Forex broker may require only $2,000 to trade a $100,000 lot of currency. If the exchange rate moves just 2 percent in the trader’s favor, she doubles her money. However, the market can just as easily go the other way and wipe her out. This is why Forex trading is so risky. Suppose a trader goes long on euros when the rate is EUR/USD 1.2500. If the eruo falls to 1.2250, a 2 percent margin is gone and the broker will close out the trade, leaving her no way to recover from the loss if the market turns around.
Limiting Forex Trading Risk
Traders must learn to manage risk to make money trading Forex. One basic tool is the stop-loss order. A stop-loss order is an instruction to the broker to close out a trade at a predetermined exchange rate so losses are limited if the market goes against the trader. Forex traders learn to use sophisticated combinations of trades to manage risk. Grid trading is one example. The trader takes simultaneous buy and sell positions in a currency. When the exchange rate moves, it will be in a favorable direction for one of the positions. At a predetermined point, the trader cashes out the positive position, leaves the other position open and opens up a new pair of buy and sell positions. This process is repeated until the overall balance is in the trader’s favor, at which point he cashes out at a profit.
Practice Before You Play
Forex trading websites frequently offer free practice Forex accounts. A typical practice account allows you to use the site’s trading platform to trade a fictional account for 30 days. You can become familiar with the charts and analytical tools traders use to follow and anticipate market trends and gain experience with trading strategies before risking real money.