It is estimated that over USD 5 trillion is traded on the currency markets in a single day. This is an indication of the popularity of currency trading around the world. Also called forex trading, where forex is the short form for foreign exchange, it draws in traders and investors alike.
What is currency trading?
But what is currency trading? Much like any other financial instruments, such as stocks or bonds, currencies can be traded too. The exchange rate of currencies is constantly fluctuating based on their demand and supply dynamics.
As an example, suppose one British pound exchanges for a single US dollar today. But tomorrow, it exchanges at 1.2 US dollars. This means that the value of the British pound has risen by 20% or as they say, it has ‘appreciated’.
Currency traders buy and sell forex based on their forecasts for these changes in exchange rates. This in a nutshell is currency trading. Some of the most actively traded currencies are the US dollar, the Euro, the Japanese Yen, the Pound Sterling and the Australian dollar.
How to trade currencies
There are various strategies from basic to advances that can be used to trade currencies. Here are three key ones:
- Day trading: This is a short-term trading strategy, in which the outcome is not carried over into the next day. For example, a trader can buy US dollars with the expectation that it will appreciate by the end of the day. Near the end of their trading day, the trader can seel the currency at the appreciated value. The increased value is the trader’s gain from the trade.
- Swing trading: This trading strategy extends beyond a day, into a week or a month. So if the US dollar is trading at a low, the trader’s analysis could say it is due to rise shortly. The trader can buy the dollar then, in the hope of an upward ‘swing’.
- Position trading: This one is for the longer term, carried out over months or years. Here the trader can buy, say, the US dollar, in expectation that it will appreciate over the years. This trader is not concerned with short term dips and rises in currency. The strategy is ideal for investors or traders who are not able to commit themselves actively to trading.
What to know when trading currencies
Before starting currency trading, it is essential to know some key features of each proposed trade:
- Leverage: Many brokers allow traders to borrow money, also known as leverage. This means that the trader deposits an amount, and the broker matches it with say, 30 times that amount. As a result, the trader stands to make a much bigger profit than would otherwise be possible with their own money.
- Exit point: It is essential to have an exit price in place. So if you as a trader expect the US dollar to appreciate by 2% in a day, once it hits that target, you can exit. It might continue to rise beyond that, but you do not know. So an exit point serves to discipline the trading and make it less risky.
- Stop loss: Similarly, you can have a stop loss in place. Even if you expect a currency to rise, the reverse might happen. The stop loss puts a limit to the amount of money you can lose. This helps in managing risks in trading.
Benefits of forex trading
If you are able to master forex trading, it can be a very rewarding way of earning money. You need very little capital, if you use leverage. At the same time, the transaction costs per trade are low too. Further, you can trade from anywhere around the world, which makes it exceptionally flexible.
Of course, the key is to know the craft. Successful currency traders do technical analysis and follow major economic events that can lead to forex fluctuations. This requires effort to keep up with the latest knowledge and learn about how global developments can affect currencies.
Suit your strategy
If you have decided to trade currencies, the most crucial decision is the time frame. If you can dedicate yourself to trading, then day trading might be it for you. On the other hand, if you have your hands full, you might take a long-term position.
A trader also has to decide which currency to trade in. The most actively traded currency is the US dollar, but there are others that are exchanged very frequently too. The decision would really depend on what the research indicates would be the most profitable position. For this, analysis of the currency markets is essential.
It might sound a bit daunting at the start, but it is not a huge market for nothing. With proper risk management in place, it could well be a profitable way to make your money grow.
