How Currency Trading Works – Fishing for Profits in a Sea Full of Money

Have you ever exchanged your money in a foreign country and gotten far less (or far more!) than you had before? Ever wonder who sets those numbers? You might be surprised to find out who the mastermind behind the world’s exchange rates are. It’s you!

That’s right. Every time your money switches currencies, you are adding and subtracting to the strength of both currencies. Millions of people doing the exact same thing you do when you change your money into another currency dictate the strength and weakness of the world’s floating economies. In fact, there’s even a business that’s evolved around exchanging massive amounts of money into foreign currencies.

It’s called The Foreign Exchange (Forex) Market, and it’s a lot like the stock market. However, there are some big differences. But before we get into Forex Trading, you need to know a little bit about how the world’s economies are run.

The Midas Touch

For many years, countries such as the United States ran their economies on what is known as the Gold Standard. The Gold Standard meant that the American government tied their dollar to the value of gold, and that for every dollar’s worth of gold there was a dollar bill printed to float in the economy.

During the 1930s, the U.S. government set the value of gold at a static 35 dollars an ounce. This set the pace for their economy, and allowed the rest of the world to use the U.S. dollar as a measuring stick to set the values of their own economies.

However, the world markets outgrew this standard after World War II, and the United States suffered from inflation. In an effort to save their dollar, they re-set the value of gold to 70 dollars an ounce, thus cutting the value of their money in half.

It worked, to an extent, but it didn’t work enough. In 1971 the United States abandoned the Gold Standard altogether, and the rest of the world followed suit.

From this point on, the American economy would be governed by market forces, creating a true market economy. Its value began to jump around as investors bought and sold as they saw fit. Some days it would be worth more, and some days it would lose value. In response, countries around the world began to set their exchange rates accordingly.

How Much is Your Dollar Worth?

Chances are pretty good that if you’ve ever been to another country than you’ve probably experienced the world of exchange rates first-hand. Exchange rates are simply the value of one currency in another currency.

Let’s say you live in the United States and you take a trip to England, for example. There’s no way the guy at the corner store is going to let you buy snacks and souvenirs with your good old American Greenbacks! You’re going to need to find a bank in order to exchange your American dollars into British Pounds—their version of the dollar.

Although it’s true that some countries like Canada allow you to shop for goods with American money, it’s an exception to the rule. The American and Canadian economies are deeply integrated with each other, making a special economical relationship between the two countries.

A Sea Full of Money

A market-driven economy is one that allows itself to be governed by the forces of Supply and Demand. The value of a dollar is based on how highly investors value it. In essence, the dollar is only worth a dollar because people are willing to say it is worth a dollar.

If everyone in the economic world suddenly decided that the American dollar was only worth 10 cents and began to buy and sell it as a dime, then the American dollar would only be worth a dime.

Sound scary? You bet it does. Supply and demand can cause wild fluctuations in the value of an economic system, and all it takes is one mass-panic sell off to throw the whole works into the trash can.

In a free-floating economic system, this is exactly how it works. The economy is given strength by investors who have confidence that a dollar is worth a dollar and are willing to buy and sell accordingly. In a free floating system, the market can be blasted with soaring highs and tamed with staggering lows. Investors can be riding high on the hog in one minute, or lose it all in another.

This is why many countries “peg” their exchange rates to a relatively stable currency, such as the U.S. Dollar or the British Pound.

A pegged system occurs when a government decides that they want their money to have a little more stability than a free-floating economy can provide. After all, while every soaring high means record profits and good times for everyone, every staggering low means lost jobs and profits, two things that can spell disaster for an economic system.

The country that decides on a pegged system decides on a stable currency to peg its own currency to. Let’s say the market at the time dictates the countries currency to be valued at about 65 cents U.S. that means that one of their dollars is equal to 65 cents in American money.

From then on, the value of the currency will always be 65 cents U.S. When the U.S. dollar goes up or down, this pegged currency will also go up or down, but it will always stay at 65 cents U.S.

Although this works well in theory, there are inherent dangers to using a pegged economy. Obviously, if the country you peg your currency to has a massive recession, then your own money will suffer, even if things are going great in your own country. Also, countries need to be careful that their exchange rate stays at the level it is pegged at. This means that they must continually buy and sell large amounts of currency to meet market demands, and keep a close eye on trends in the market to counter any fluctuations that may cause their exchange rates to change.

It is a constant balancing act

In reality, there are very few countries that run on pure forms of either economic system. The majority of countries use a hybrid form that mixes both systems together, thus hoping to take advantage of the best qualities of both free-floating and pegged currencies.

Stability is maintained by pegging the currency’s value, but the rates are re-assessed regularly and re-pegged depending on the strength or weakness of the currency at the time.

It makes for an extremely complicated system. It truly is a sea full of money. Fortunately, for those brave enough to sail the waters of the world’s economic ocean, there is a fortune out there waiting to be made.

Fishing the World’s Economic Ocean

When the world currencies began to measure their economies according to supply and demand, all those fluctuating numbers made investor’s eyes sparkle. The profit potential in such a volatile market could be limitless, if it was handled properly. This is where the buying and selling of money really began. The first Foreign Exchange (Forex) clearing houses began to spring up, allowing people to buy and sell foreign currencies by the thousands.

At first this opportunity was available only to banks and large international corporations, but the system was opened to the entire world in 1995. These days, anyone with a few dollars in their pocket can play the Forex markets and test their luck. The Forex Market is an unregulated system that runs entirely off of supply and demand. As such, the market is as volatile as they come. Because of this, the Forex Market is subject to wild swings and strong trends.

This can make it extremely dangerous for an uninformed investor. If you can’t read the market signs properly, you could be in for some serious financial trouble.

The Forex Market is open 24 hours a day, from Sunday night to Friday afternoon. In that time, it has a volume of over $1.5 trillion. That means that every day more than 1.5 trillion dollars change hands though buying and selling.

Compare that to a measly $16 billion by the New York Stock Exchange and a sickly $11 billion by the London Stock Exchange, and it’s easy to see what attracts investors to such a turbulent market.

Spotting a Good Deal

Spot Trading is the most common type of trading in the Forex Market. Spot Trading means that for whatever reason, an investor buys and sells in a specific currency to the exclusion of most others.

Buying and selling occurs in pairs. An investor buys in one currency while simultaneously selling in another. For example, an investor might decide to buy American dollars while selling Japanese Yen.

It’s as simple as exchanging your money into another currency that is lower than your own, and exchanging it back when that currency improves. In fact, simply by exchanging your money into someone else’s, you are helping to strengthen that currency. However, because the market is affected by ALL of the investors doing the same thing you are, you can see where the inherent unpredictability and the need to recognize trends in the market become important.

To combat this unpredictability, there are two basic strategies in Forex Trading:

1. Technical Strategy

   Technical Strategy is a term used to describe the act of predicting market trends by looking at a currency’s past growth, volume, and exchange rates and comparing them to a current trading situation. Technical Strategy is used to see how a currency has reacted to market shifts in the past, and how successful it was at rebounding from highs and lows. Using this information, an investor hopes to make an informed decision on the future of the currency.

2. Fundamental Strategy

   Fundamental Strategy is a term used to describe the act of predicting market trends by comparing its ethical, political, and monetary policies to the value of its current exchange rate. Political instability and protective monetary practices can greatly affect how a country’s currency will be viewed by Forex investors. It pays to keep an eye on the political stage when considering an exchange.

Another tool used by Forex traders that can be a source of incredible profits is the use of leverage. Leverage is a way for large amounts of cash to change hands without all of the hassles of actually moving the money.

Traders use leverage to represent large sums of currency. For example, if a trader uses a leverage of 100 on $1000, his money is effectively multiplied by 100. That means his $1000 represents $100,000, or 100 times his original investment.

Using leverage, a trader with access to an infinite amount of cash can trade in much larger numbers than he or she might normally be able to. It’s like a down payment on the money. By trading a small amount, the trader acknowledges that they are responsible for whatever the leverage multiplier is. In the preceding example, the trader uses $1000 dollars but is responsible for the full $100,000.

This leverage goes both ways. Should the currency pay out for the trader, than the profit margin is set for the full $100,000. Of course, if the currency tanks out, then the trader is responsible for the difference. This can add up to millions of dollars very quickly.

Because of this, leverage should be used very carefully by experienced traders only. Even then, there are no guarantees.

The Forex Market is an exciting and explosive place for investors to explore, but it is not a place for the weak-of-heart or conservative-minded investors. The potential for loss and gain are equally high.

It has grown exponentially since it was opened up to the public in 1995, yet it is not nearly as well-known as the more traditional stock markets. Experts attest this to the fact that there is no centralized place where currency trading exists, so there is no visibly recognizable symbol such as Wall Street.

Anyone with an internet connection and some investment capital can dip into the Forex waters. But anyone who does, should be forewarned: The waters here are deep and filled with sharks, and there are no life preservers if your boat starts to sink.

About The Author

Bill Schnarr is a successful freelance writer providing tips and advice for consumers about legal separation rules, consumer credit counseling services and secured credit card. His numerous articles offer moneysaving tips and valuable insight on typically confusing topics.

This article on the "How Currency Trading Works" reprinted with permission.

© 2004 - Net Guides Publishing, Inc.