How Do Foreign Exchange Traders Make Money?

Foreign exchange traders speculate about the direction of major currencies.

Foreign exchange traders speculate about the direction of major currencies.

The largest trading market in the world is not located in any single place; it's worldwide and open around the clock, five days a week. Foreign exchange, or Forex, traders buy and sell currencies, either to hedge their investments or to speculate on the direction of dollars, euros or yen. On the surface, it's a simple game with a limited menu of options; about a dozen major currencies are traded actively. In reality, currency trading is one of the more difficult speculations that traders can attempt.

Currency Pairs

Currency traders deal in pairs, with one major currency constantly rising and falling in value against another. The most commonly traded pairs are the euro/U.S. dollar, known as the EUR/USD; the U.S. dollar/Japanese yen or USD/JPY; and the British pound/U.S. dollar or GBP/USD. The pairs are quoted with a single price, representing the amount of the second currency ("quote currency") that the first one ("base currency") will buy. A EUR/USD quotation of 1.50, for example, means that one euro will buy $1.50.

Trading

Except for the USD/JPY, currency pairs are quoted to four decimal places, with the smallest fraction known as a "pip." A EUR/USD pair might be quoted, for example, at 1.2567/1.2570 -- a three-pip spread. The lower "bid" price is the offering price if you wish to "sell" the pair. The higher "ask" price is the price at which a trader can "buy" the pair, meaning he is speculating on a rise in the euro against the dollar. The larger the price spread, the more the pair has to move in the desired direction for the trader to make a profit.

Considerations

Traders buy or sell currency pairs without broker commissions; the pip spread represents the broker's profit margin. Currency trades are made on margin, meaning a percentage of the funds needed to open the trade are borrowed. The standard currency position involves 100,000 units of the base currency, but currency brokers also offer "mini" lot trading of 10,000 units and "micro" lot trading of 1,000 units. Only a small fraction of the money needed to open the trade is deposited with the broker, meaning that currency trading involves both high potential reward and high risk.

Technical and Fundamental Analysis

Traders study many information sources to develop a consistent trading system. Some prefer fundamentals -- basic, real-world information that tends to move currency values, such as reported government deficits, interest rates, trade balances, economic growth and news events. Others trade with technical analysis -- the study of price charts and mathematical indicators to understand developing trends in currency prices. No matter which system is used, however, exchange rates are always subject to sudden, unpredictable and wide price swings that don't conform with expectations, making this type of investing more art than science.

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