Forex, which is short for Foreign Exchange, is another term for currency trading. The goal of forex is try to profit by trading the ever-changing currency exchange rates, such as the Euro versus the U.S. Dollar.
Exchange Rate Example
One of the most popular currency pairs is the EUR/USD, which tracks the Euro against the U.S. Dollar. If the EUR/USD is at 1.5000, that means one Euro will get you 1.5000 U.S. Dollars. One thing that's interesting about these exchange rates is that they are relative to two countries. If the Euro gets "stronger", the rate goes up to 1.5785, for example, because you can buy more Dollars. If the Dollar gets stronger, the rate will drop because the Euro will buy fewer Dollars. However, if both the Euro and the Dollar get stronger (or weaker) by the same amount, the rate won't really change!
Similar to Stock Trading
Currency trading actually has many similarities to stock trading. Many people are familiar with how stock trading works: find a price quote for a company using its symbol, then buy that symbol at a low price and sell it later at a higher price hopefully. Forex is actually very similar: get a quote for a symbol like EUR/USD, buy it at a lower rate like 1.4000 and then sell it at a higher rate like 1.4050.
Meet the Pip
Since the exchange rates change by such a small percentage, a term called the pip is used to describe changes in rates or profits. For example, if the GBP/CHF (British Pound versus Swiss Franc) goes from 1.7000 to 1.7001, it has increased by 1 pip, and an increase to 1.7100 would be 100 pips because for this pair one pip is 0.0001. However, for a rate like 95.00 for the USD/JPY, the pip represents 0.01, so 95.01 would be a 1-pip gain while 96.00 would be a 100-pip gain. This just describes the rate differences. To calculate your dollar gains, you need to factor in the lot size (see below).
The Spread instead of a Commission
Forex brokers make their profits not by charging a commission on each trade but by creating a small difference between the Bid (Sell) and Ask (Buy) prices. This is called the Spread and it is measured in pips. A typical spread might be between 1 and 10 pips. So if you bought and then sold right away, you would actually lose money by the amount of the spread. For example, buying EUR/USD at 1.5000 (the Ask) and selling at 1.4995 (the Bid) would be a loss of 5 pips.
Lots of Lots
Stock trading involves buying shares but forex trading involves buying lots. Depending on the account type, the lot size will be something like 1K, 10K, or 100K. Assuming your account has a 10K (10,000) lot size and you buy 8 lots, that would be a total contract size of 80K. It is important to realize that you must place your trades in increments of the lot size.
Margin and Leverage
Since currency rates change by such small amounts at a time, most forex brokers offer a large amount of leverage, such as 200 to 1. That means you only use $1 of your actual cash for every $200 of a currency pair that you purchase. For example, if you buy 10K of EUR/USD at 200:1 leverage, that would only require $50 of cash because 10,000 divided by 200 is 50. The purpose of the leverage is to amplify your profits but keep in mind it can just as easily amplify your losses. Many, many traders have lost all of their trading money because of leverage, so be careful!
Practice Trading
Many forex websites offer free demo programs that allow you to practice trading with virtual money, often for a limited time. HowTheMarketWorks has an online forex game that does not have a time limit. Practicing with these demo programs is highly, highly recommended until you become comfortable with the trading process and the dangers of leverage.
