The way that it works is based on exchange rates, which is one currencies value in comparison to another. When it is anticipated that the value of one currency is to rise in the near future, you would purchase it at the lower rate of exchange. Once it increases in value, you will have made a profit and, as such, have increased your buying power.
The rates of exchange are changing all the time. It is very rare that you would find two currencies with the same exact exchange rate, or that they will hold that value for any significant length of time. As a result, the market is constantly moving and changing and the capabilities to make a profit are endless.
The reason the rates are constantly changing works very similarly to how the stock market fluctuates. It is based on supply and demand and external influencing factors based on the economic trends in particular countries or regions. One of the biggest differences between foreign exchange trading and the stock market is that you can lose or profit regardless of market conditions. There will never be a “down” time where there is only potential loss.
Something to take note of when considering this type of trading, is that you can pair any currencies for exchange. For example, if you think that the dollar is soon to lose value, you might consider selling dollars and buying euros. If after buying the euros, the dollar does in fact decrease in value, you can then buy dollars at the new lower rate of exchange.
When looking at foreign exchange, you will be reading quotes in pairs of two currencies. Using the example we just mentioned, USD/EUR at.8091 will tell you what your dollar is worth in euros and is always carried to fourth decimal place. This is also what is used to count “pips.” The pip is the term used to express profit or loss. So, for example, if the USD/EUR rose from.8091 to.8095, you would say that it has risen 4 pips.
In the exchange of foreign currency, the smallest amount that can be traded is 1,000 units. Regardless of what currency is being exchanged, the smallest amount you can exchange is considered a “lot.” Most lot sizes are 1,000 units of whatever currency is being exchanged. You might, for example, say that you are exchanging 500 lots of USD. What this translates to then, is you are exchanging $500,000.
Again, in foreign exchange you are trading using borrowed money. So basically, you have a set amount of money that is held in an “escrow” account for you. And then based on the margin of leverage, you are able to actually control a much larger amount of money than you may actually have. For example, with a margin of 500:1, you would only actually need $2.00 in a deposit account to be able to trade $1000.
While leverage allows you to the flexibility to transact with more than you deposit, you still have the potential to win or lose in larger amounts too. It’s important to consider the investment opportunity as well as risk. Leverages, even in smaller margins, are not always the best option.