Foreign Currency Exchange: The Basics

The world of foreign currency trading might have great appeal, but you should be aware of the risks before starting to trade

The world of foreign currency exchange is so big, it is sometimes hard to grasp. With daily trading volumes of $3.5 trillion(!) – it is considered the world’s biggest market. While the basic idea of trading currencies is simple, there are still some important things to know before getting onto the rollercoaster which is online currency exchange.

At it’s core, the foreign exchange market works in a straightforward way: A trader buys one currency using another, in the hopes that the latter will go up in value against the former. However, since currency exchange rates are constantly changing, and there are a number of mechanisms to be utilized when trading them. There’s more to this world than just buying low and selling high.

Small movements, high volumes

The first thing that’s important to know about currencies is that they move in very small units. Unlike other assets, such as stocks or commodities, foreign currency trades are sometimes done in margins as low as 0.0001%, known as “pips.” Therefore, traders often conduct deals that are extremely short-term, sometimes opening and closing within minutes. This form of trading is known as “scalping,” and traders who use scalping normally conduct many transactions throughout the day. While not the only way to trade foreign currencies, since it is possible to hold currencies for longer periods, and wait for bigger gains over-time, it is a popular way to trade.

Since making significant profit with such small margins requires a lot of capital, most foreign currency trades are leveraged. Leveraging is a service provided by trading platforms, which loans a fix multiplied amount for every dollar invested, and can go as high as 400 to 1. For example: If a trader invests $100 and leverages the deal 10 to 1, they will have $1000 to invest.

Despite the fact that a leveraged deal can generate more profit, it is widely considered a double-edged sword, since losses are also leveraged and can deplete accounts quite quickly. Using the previous example, if the aforementioned leveraged deal falls short, and 10% is lost, the entire deposit of $100 will be deducted from the account. Therefore, it is very important to use a stop loss order.

Know your boundaries

When entering a trading contract, it is possible (and quite recommended) to set a stop loss point. The stop loss order automatically ends the deal when a certain amount is lost. However, since sometimes markets move quite quickly, the stop loss order is not a complete guarantee. Let’s say a trader set a stop loss point at a loss of 0.5%, if the market shifts quickly (a movement known as slippage), and goes from -0.4% to 0.7% in an instant, the stop loss will be triggered at an additional loss of 0.2%. It might not sound like much, but at high volumes it could add up to quite a hefty loss.

The opposite of  stop loss is a take profit order, which stops the transaction at a predetermined profit point. Similarly to a stop loss, slippage can also occur with this order, only in this case, it would work in favor of the trader. Most traders recommend setting both orders for each short-term transaction, as it gives you a clear idea of the boundaries in which the deal will take place.

Remember that all forms of trading involve risk, and it is best to educate yourself before making important decisions, to make sure risks you take are calculated. While the fast-paced world of foreign currency trading may be have the appeal of quick returns and high profits, it is also extremely volatile and unpredictable.

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