If you have ever bought foreign currency for an overseas trip, then you will probably be familiar with exchange rates, which usually look something like this:
GBP £/USD $ = 1.5400
The currency on the left of the slash (the British pound) is known as the base currency, and the currency on the right (the US dollar) is known as the quote currency. The number after the equals sign (“=”) is the amount of the quote currency that you can buy with one unit of the base currency. In this case, it means that you can trade £1 for $1.54.
Most of the trades on this exchange are made by large financial organisations such as banks, and it is estimated that currency worth over $4 trillion changes hands on the forex market on a typical trading day.
Exchange rates are constantly changing to reflect the level of supply and demand for currencies on the foreign exchange market. This makes it possible to make profits by buying currency when it is cheap and then selling it when it becomes more expensive.
In the past, it was virtually impossible for a private investor to make forex trades, due to the size of the stake required and the costs involved. This has all changed in recent years with the emergence of firms that offer internet-based retail forex trading, such as Saxo Bank and CMC Markets. These services allow individual investors to trade on margin, which is a way of trading large sums of money without having to deposit huge amounts of capital.
For example, you could buy £50,000 worth of US dollars with just £500, a margin of 1%. At a GBP/USD exchange rate of 1.5000, that would get you $75,000. If the exchange rate then fell by 100 percentage points (pips) to 1.4900, and you sold the dollars, your $75,000 would now be worth £50,335.57 – earning you a profit of £335.57. However, if it went the other way, there is a risk that you could end up owing more than your initial stake.
There is always a slight difference between the rate at which you can buy currency, and the rate at which you can sell it. This difference is known as the ‘spread’. The spreads are set by the forex brokers themselves, and the buy, or ‘ask’ price is always higher than the sell, or ‘bid’ price. Therefore, in order for you to make a profit, the exchange rate must move in the right direction by more than this amount. The smaller the spread, the more money you stand to make if you call it right.
The basics of forex trading are relatively easy to understand. Predicting the movements of currencies, on the other hand, can be very tricky indeed. The currency market is a complex beast, with a huge number of factors influencing the value of every currency listed on the exchange. At best, an investor can only make an educated guess about which way a currency is going to move, and by how much. To succeed, you will need to develop an intimate knowledge of the factors that can influence the valuation of a currency, and keep up to date with developments in the financial world.