What Is Currency Trading?
Currency Trading Explained
Currency trading is buying or selling currency pairs in the foreign exchange market at a specific exchange rate. The forex market is one of the largest and most liquid markets in the world, reaching a daily turnover of $6.6 trillion in 2019.
In its simplest form, if you travel internationally, you might already have engaged in currency trading.
Before you travel to, say, Canada from the United States, you might exchange your American dollars for Canadian dollars. You use American money to buy Canadian money. Depending on the foreign exchange rate at the time, you might be able to secure $1.26 Canadian (CAD) in exchange for $1.00 USD. Of course, this exchange rate constantly fluctuates. This is where currency trading, as an investment, comes in.
Learn more about currency trading, including the key details you need to know if trading currency interests you.
Definition and Examples of Currency Trading
If you trade currency, you’ll do it on the foreign currency exchange or Forex market. As with the travel example, you use one country’s currency to buy the currency of another country. You buy and sell currency on the basis of the direction you think each currency will trend in relation with one another.
A currency pair is simply the two currencies you trade against one another side by side, identified as a three letter abbreviation for each currency. So you’ll typically see the United States dollar/Canadian dollar pair represented as (USD/CAD). The yen and the euro pair is represented by (JPY/EUR).
When you go to trade a currency pair, you’ll run into terminology similar to what we commonly use with stocks. Each currency pair has an ask and a bid. The ask represents what it would cost you to purchase a currency, whereas the bid is what you’ll receive if you sell the currency. The difference between the bid and ask is the spread.
You’ll see currency pairs quoted using “pips,” or percentage in points. Typically, a pip is equal to 1/100 of 1 percent or equivalent to 0.0001. We use the pip to calculate the bid/ask spread
You make or lose money based on the buy/sell decision you make and the direction your currency pair moves.
If you purchased the appreciating currency in a pair, you’ll earn profits. You’ll incur losses if you sell the appreciating currency.
For example, let’s say the EUR/USD pair was trading at 1.11250, with an ask of 1.11255 and a bid of 1.11246 and you wanted to trade it anticipating an appreciation in the euro. For the sake of simplicity, let’s assume no margin or transaction costs. You would buy a “lot,” typically 100,000 units at $1.11255. This trade is the equivalent of buying €100,000 for $111,255.
If the dollar depreciates against the euro, you make a profit. Let’s assume the EUR/USD now trades at 1.11590, with a buy price of 1.11595 and a sell price of 1.11588, your €100,000 are now worth $111,588 (100,000 x 1.11588) instead of $111,255 earlier. So you close the position by selling the €100,000 and getting the higher dollar value in return.
If the dollar strengthens against the euro, you will have a loss. Let’s assume the EUR/USD now trades at 1.11020, with a sell price of 1.11016. Your €100,000 are now worth $111,016 (100,000 x 1.11016) instead of $111,255 earlier. So if you close the position now by selling the €100,000 and you will get a lower dollar value in return.
What to Look Out For If You Trade Currencies
While this all sounds straightforward, there’s considerable risk associated with trading currencies. It cannot be stressed enough that you should educate yourself extensively before trading currencies. Until you have a firm grasp on how currency pairs function in what is a very fluid and often volatile market, you should hold off on trading real money. Consider observing trades or using a mock account to make hypothetical trades without putting actual cash at risk.
Here are a few critical things to look out for when considering currency trading.
Currency traders often use leverage in their forex accounts, which means you put up a relatively small amount of money yet receive buying power often many times the actual cash in your account.
Also known as margin trading, the use of leverage can lead to out-sized gains as well as losses. On the positive side, using leverage allows currency traders to profit on a very small move between currencies.
On the potentially negative side, it doesn’t take much of a move against your trade for you to lose your entire investment or more.
Remember, when you trade on margin, you’re borrowing money from your broker. Depending on their policies, at some point in a busted trade, you might receive a margin call, which means you owe your broker money to satisfy the loss of the capital you borrowed.
Non-Uniform Quoting Conventions
The currency pair (USD/CAD) means one U.S. dollar purchases a specific amount of Canadian dollars, and while many currencies are quoted against USD, there is no worldwide convention spelling out how the currency pairs are named. For example, the currency pairs of the U.S. dollar with the euro may be quoted in reverse order–(EUR/USD), which means one euro purchases a specific amount of U.S. dollars.
If you’re trading in the forex markets, pay heed to how the pairs are quoted and what a movement in a quote means for your trades.
Just like the stock market, there are costs associated with trading in the forex market. With few rules surrounding commissions, it is often left to the dealer to decide how and how much to charge. Some forex dealers charge per trade, some through a wider bid-ask spread, and some with a combination of both.
“Commission-free” trades may still attract some costs and those can add up if you’re trading frequently or “scalping.” Large transaction costs for certain currency pairs can quickly turn profitable trades into loss-making ones.
Beware of forex trading scams. If an offer from a company that facilitates currency trading sounds too good to be true, it probably is. Watch out for offers of huge returns on relatively small investments.
Some countries have unstable currencies that can collapse or trade with considerable volatility. You don’t want to get caught up in country risk in a currency trade, especially if you lack experience navigating the space.
Currency trading isn’t for everyone. As with any trading vehicle you put your money in, it takes time to get comfortable with the intricacies and risks associated with the currency markets. If you don’t use a practice account, start small. Only risk a modest amount of money you can afford to lose.
As with trading stocks or options, if you see early success trading currency, don’t get greedy. Don’t fall victim to a false sense of confidence as a result of winning on your first few trades.
- Currency traders use the currency of one country to buy the currency of another country.
- In a currency trade, you profit if you purchased the appreciating currency in a currency pair. You’ll see losses if you sold the appreciating currency.
- Beware of risks associated with currency trading, particularly the common practice of using leverage to enhance the potential gains in a trade.
- High leverage or margin trades in forex means you could lose more than your initial investment.
- Understand the transaction costs involved, as they can add up can turn profitable trades into losing transactions.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.