How Does Foreign Exchange Trading Work?

Forex concept with world globe
Courtney Keating/Getty Images

Foreign exchange trading was once just something that people had to do when traveling to other countries. They would exchange some of their home country's currency for another and endure the current currency exchange rate.

These days, when you hear someone refer to foreign exchange trading, they are usually referring to a type of investment trading that has now become common. Traders can now speculate on the fluctuating values of currencies between two countries.

It's done for sport and profit.

Beginner Trading

This seems like something that most people would find easy, except, in this particular industry, there is a high rate of failure among new traders. Even traders that are aware of that tend to start out with the attitude of "It happened to them, but it won't happen to me". In the end, 96 percent of these traders walk away empty handed, not quite sure what happened to them, or maybe even feeling a bit scammed.

Forex trading is not a scam; it's just an industry that is primarily set up for insiders that understand it. The goal for new traders should be to survive long enough to understand the inner working of foreign exchange trading and become one of those insiders.

The number one thing that hangs most traders out to dry is the ability to use forex trading leverage. Using Leverage allows traders to trade on the market with more money than what they have in their account.

For example, if you were trading 2:1, you could use a $1,000 deposit, to control $2,000 of currency on the market. Many forex brokers offer as much as 50:1 leverage. New traders tend to jump in and start trading with that 50:1 leverage immediately without being prepared for the consequences.

Trading with leverage sounds like a really good time, and it's true that it can increase how easily you can make money, but the thing that is less talked about is it also increases your risk for losses.

If a trader with $1,000 in their account is trading with 50:1 and trading $50,000 on the market, each pip is worth around $5. If the average daily move is 70 to 100 pips, in a day your average loss could be around $350. If you made a really bad trade, you could lose your entire account in 3 days, and of course, that is assuming that conditions are normal.

Most new traders being optimistic might say "but I could also double my account in just a matter of days." While that is indeed true, watching your account fluctuate that seriously is very difficult to do. Many people start out assuming that they can handle it, but when it comes down to it, they don't, and forex trading mistakes are made.

Avoiding Mistakes

Assuming that you can manage not to fall for the leverage trap, you'll need to have a handle on your emotions. The biggest thing that you'll tackle is your personal emotions when trading forex. The availability of leverage will tempt you to use it, and if it works against you, your emotions will have your vision upside down, and you will probably lose money. The best way to avoid all of this is to have a trading plan that you can stick to. Not only should you have a trading plan, but you should keep a forex trading journal to keep track of your progress.

You might feel when looking around online, that other people can trade forex and you can't. It's not true; it's just your self-perception that makes it seem that way. A lot of people that are trading foreign exchange are struggling, but their pride keeps them from admitting their problems, and you'll find them posting in online forums or on Facebook about how wonderful they are doing when they are struggling just like you.

Winning at trading forex online is an achievable goal if you get educated and keep your head together while you're learning. Practice on a forex trading demo first, and start small when you start using real money. Always allow yourself to be wrong and learn how to move on from it when it happens. People fail at forex trading every day for lack of ability to be honest with themselves.

If you learn to do that, you've solved half of the equation for success in forex trading.