Forex investing has emerged as one of the the hottest topics in the world. Forex trading basically allows you to make money off of fluctuations in exchange rates. Once upon a time, exchange rates were fixed, either to other currencies, or to commodities, such as gold and silver. In the age of the fiat currency, exchange rates are allowed to float in a free trading market.
And where there is a free trading market, there is a potential to produce profits. Since forex rates move up and down, you can actually make money off of the price movements themselves. As often is the case in the financial world, it’s easy to illustrate how forex markets work through an example. Below is an example of currency exchange rates, and following that we’ll explain what this means for forex trading.
A Tale of Two Currencies: The Dollar and the Euro
For a long time the euro was trading much higher than the American dollar. In fact, until recently, one single euro generally bought about 1.4 dollars. This meant that the euro was a much stronger currency than the dollar. In 2014, however, the European Union’s on-going financial and fiscal crisis came to a head and investors, traders, and others began to lose faith in the E.U.
As a result, the euro began to suffer from a gradual but steady decline. In May of 2014, a euro bought about 1.39 USD. By December of 2014, the euro could buy only about 1.25 USD. Then in January of 2015, the European Union unveiled a massive quantitative easing plan. With quantitative easing, governments essentially create new money and then buy assets, such as mortgages. This pumps money into the financial system, thus increasing liquidity.
Basic economics stipulates that as the supply of something increases, prices should decrease. The same is true for currencies. As the supply of euros in the market increased, the value of each individual euro in comparison to the dollar declined. By March of 2015, a euro could only buy 1.05 American dollars. The value of the euro has since increased incrementally, but a euro still buys less than $1.10 dollars, as of January 2015.
What This Means For Forex Trading
So what do these fluctuations in forex rates mean for traders? Let’s say that you had a savings account of 100,000 euro in May of 2014, but realized that the euro was going to lose value. As such, you decided to exchange your euros for dollars, and you ended up with a savings account worth about $139,000 dollars. Then, in January of 2016 you exchanged your dollars for euro.
You would be able to buy about 129,000 euro with your $139,000 American dollars. But remember, you originally bought your dollars with 100,000 euro. This means that from May of 2014 until January of 2016, you were able to produce a profit of roughly 29,000 euros. That’s a huge profit, and you were able to produce it merely through foreign exchange. Foreign exchange trading, however, isn’t the only way to trade currencies, you can also use Forex.
Forex exchange trading is basically a turbocharged version of this. The above example of euro verse dollars actually represents one of the most dramatic fluctuations in exchange rates in modern history (at least among major developed countries). While stock markets often move at roller coaster rates, rising and falling quickly, foreign exchange markets often move much more slowly.
Forex markets refer to the mass exchange of currencies in massive amounts. Huge companies, governments, and financial institutions often have to trade vast amounts of money, and they do so through forex markets. Investors can also profit off of investing in forex.
Basically, you can exchange one currency for another, and hope that exchange rates either increase or decrease, depending on what you invested in. With forex, because markets move so slowly, you can often leverage huge amounts of money, often set at 200 to 1. This means that you can borrow up to $200 dollars for every dollar you yourself invest in.
Does that sound crazy? Institutions are able to offer such massive amounts of leverage because forex markets generally move quite slowly. Be careful, however, the more you leverage, the higher the risks will be.