Understanding ForexForex – also known as FX – is short for “Foreign Exchange”. It represents a market where one can exchange and trade different currencies across the globe. To understand how forex works, let’s use the example of overseas travel.
If you’re from the United States and are travelling to Japan, chances are you would head to a local currency dealer before your trip to change some US dollars for the equivalent in Japanese yen. Let’s say the rate you exchanged was 1 USD ( US Dollar ) to 108 JPY (Japanese yen). This means that for every 1 USD you give the money changer, you get 108 JPY in return.
Now you’ve headed off on your trip, had your lifetime’s fill of sushi, taken way too many pictures of Mount Fuji and are now back in the US a month later. You still have some Japanese yen currency left which, of course, isn’t of much use at American shops, so you decide to change it back to USD.
Once again you visit your local currency dealer and ask to change your JPY back to USD. The rate you’re quoted is now 104 JPY to 1 USD.
Let’s pause for a moment: you may not have realised, but you’ve just made a profit without even planning to!
Previously, every 1 USD got you 108 JPY, now you get that same 1 USD back for just 104 JPY. That, my friend, is a simplified explanation of how profit can be made by trading the fluctuation of currencies against each other. In this case, the JPY strengthened against the USD while you were holding onto it, resulting in you effectively making money when you returned to the US and decided to convert it back to USD.
Now, it’s important to take note that when trading Forex, you always need to consider two currencies (hence, we call it a “currency pair”). In the above example, we were essentially trading the USD/JPY currency pair. It’s not enough to think that one currency might strengthen – you have to think of which currency it would strengthen against.
Thanks to the globalisation of financial markets, when we trade on the FX market, we now have the luxury of trading a lot of different currencies against each other all from the comfort of your home. Think the yen is going to strengthen against the Euro (EUR)?
Then buy the yen, sell the Euro (selling EUR/JPY )! This concept might seem a bit complicated right now, but just remember that when you’re trading forex, you’re essentially betting that one currency will strengthen against another currency.
* * The exchange rate on the chart is 104.056 Japanese Yen (JPY) for every 1 United States Dollar (USD) **
