The way one makes money in the Forex market or any other type of market for that matter is simply through buying and selling securities. Obviously, in order to make money on the Forex market, you have to buy low and sell high. Obviously, the main purpose of trading is to make money and in the Forex market, you make money by exchanging one currency for another currency, assuming that the currency exchange rate will change and go in the direction you forecasted.
If for whatever reasons, either technical or fundamental reason, you believe the EUR/USD exchange rate will rise, you simply want to buy and go long. In the financial world, when a security or an instrument is rising in value in a persistent way, we call that a bullish trend.
Conversely, if for whatever reasons, either technical or fundamental reason, you believe the EUR/USD exchange rate will decrease, you simply want to sell and go short. In the financial world, when a security or an instrument is decreasing in value in a persistent way, we call that a bearish trend.
Where does Trading Take Place?
Depending on what security you’re trying to buy or sell there are two places where trading takes place:
- Trading on Exchanges: An exchange is an organized marketplace where you can buy and sell a variety of instruments like shares (E.g. New York Stock Exchange), futures and options (E.g. Chicago Mercantile Exchange). As technology has evolved so has the stock market, as the majority of transaction happens electronically and orders are matched more efficiently.
- Trading Over-the-Counter (OTC): In an OTC environment trades are made directly between two parties. All the trading activity happens through decentralized dealer networks. The world’s biggest and most liquid market is the Forex market, which is actually traded over-the-counter. This means that there is no physical exchange where Forex trading happen, which is done electronically within a network of bank dealers and brokerages that deal directly with each other.
How to Trade?
Before opening a trade you have first to decide what instrument to trade. Secondly, you’ll have to decide if the trend is either bearish or bullish, which ultimately will help you determine whether you should buy or sell.
Normally, when we’re moving in a bullish trend you want to buy and conversely when we’re moving in a bearish trend you want to sell. Last but not least, when opening a trade, you also have to decide on your trading size, where to take profits and where to hide your stop loss.
How does Trading Work?
For every BUY order executed there must be an equivalent opposite BUY order in order for a transaction in the market to happen. Conversely, for every SELL order executed there must be an equivalent opposite BUY order in order for a transaction in the market to happen. These two opposite orders are equal; all you need to do is to agree on the price.
Then how do stocks move up and down?
If there is a buy order for every sell order how the stocks move up or down? And who decides this? These are all very legitimate questions that deserve an answer. The truth is that there are several key factors that cause stocks to move up and down and at the most very basic level the supply – demand imbalances drive stock prices.
The supply side is represented by the total shares that people want to sell, and the demand side is represented by the total shares that people want to buy. When the supply side equals the demand side we have what is called the equilibrium price.
EUR/USD Trade Example – A case Study
Now, let’s have a look at a real example. Throughout this example, we’ll answer a very important question: How much money can you theoretically make by trading currencies? For this purpose, we’re going to look through a hypothetical trade example, which will shed some lights on how money is made by trading Forex currency pairs.
Let’s assume that you have $1,000 on your Forex trading account. The current exchange rate of the EUR/USD is 1.25. In other words, for 1 euro you get 1.25 US dollars. You forecast and anticipate that during the current day euro will rise against the US dollar. Based on your analysis you buy 800 euros for your $1000, your initial deposit.
Your forecast is correct!
The EUR/USD exchange rate rises from 1.2500 to 1.2600 which is a 100 pips movement. Being in profit you decide to close the trade and exchange 800 euros back to $1,008. In effect, your profit on this trade is $8.
Not that much, right?
What if you could potentially increase your existing profits? In order to maximize your profits, you can simply use leverage. Usually, if something costs $10,000 you need to pay $10,000 for it, that’s common sense. However, in the currency market, you don’t have to have the whole price of what you’re buying; you only have to deposit enough money to cover possible losses.
The deposit you put up is called margin, the broker then lets you trade a certain multiple of that margin and this is called leverage. Basically, leverage is a loan that gives you the possibility to make bigger returns relative to the amount invested.
With higher leverage also means not only more profit potential but also much larger losses. In this regard, managing your risk is very important because there is a danger to lose more than your initial deposit. When using a leverage of 1:100 your purchasing power increases 100x time your account balance.
Coming back to our example, this means that with $1000 we can control $100,000 buying power. Under the same above scenario where we forecasted that the EUR/USD exchange rate will rise, if you decide to use the whole buying power available for trading you open the same long trade but with a position size equivalent to $100,000.
At the moment when you close the trade and return the loan to your broker, you are now left with a bigger net profit of $1000. An incredible result after just one trade you were able to double your initial investment.
Trading the financial markets can be done not just through buying securities, but through selling securities as well. You can actually make money from both buying and selling, but the key to trading successfully is to buy low and sell higher.
Not all markets provide you with the same level of accessibility and in this regard, the Forex market can be a great start of your trading career, especially if your initial investment is not that much. Through the power of leverage and compounding making a lot of money trading can be achieved if you’re able to find an edge.
Thank you for reading!