Trading the FOREX or ‘FOR’eign ‘EX’change or FX, is simply exchanging one monetary currency for another. In other words, the foreign exchange market trades money itself.
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LETS ALL GO ON A HOLIDAY
Let’s take a simple example to explain in more detail. Let’s say you’re going on a 5 week holiday from the US to France. Obviously you’d need Euros to pay for things in France, like your food, gifts, etc. So what do you do? You go to a “bureau de change” or foreign exchange office, (at the airport for instance), and you exchange your Dollars into Euros. This enables you to buy stuff in France with your Euros. The bureau-de-change office will quote you the current exchange rate (also known as price), so for example, for every USD, you might get 0.75 Euros. So maybe you want to exchange a thousand Dollars into Euros. So that would mean $1000 = €750. Not bad, 750 Euros to spend in France!
Then, after 5 weeks, when you return back from your holiday, you’ll want to swap your Euros back into US Dollars. Take note – the exchange rate will probably have changed a little, and you might get a better or worse deal. For example, maybe you didn’t spend much in France, only spending about €250, which means you’re left with €500 Euros. So you wanna swap this remaining €500 back into USD. All you do is go to the bureau-de-change/foreign exchange office, and exchange currencies, i.e. Euros into Dollars. However, the current rate will most likely be different, and you might get a better deal. So if you swap your 500 Euros into US Dollars, you might get back $1000. Hang on a second… but didn’t you have 1000USD to begin with before setting off to France? Yep. It’s just that the forex rate has changed so much, that it’s benefited you a great deal, where you’re now getting 2 Dollars for every Euro.
Ok ok, so now that’s got us thinking. WHAT IF you didn’t spend any Euros in France? (Let’s just ignore the fact that you’d need to spend some money on food). So you’ve spent nothing in France, and therefore brought back the same 750 Euros you started off with. That’s right, you’d be pocketing $1500 back in the US. That’s 500USD profit! Okaaaay, so going one step further, what if you didn’t even bother going to France, and just swapped your 1000 Dollars into Euros, waited 5 weeks sitting at home in the US, and swapped the Euros back into Dollars? Same thing, you’d get a cool $1500. Beginning to get the picture? It is the exploitation of this very fluctuation in the currency markets, that allows a Forex trader to profit. So, how do Forex traders know which currency is getting stronger and which is getting weaker? They don’t. But there are systems/methods that allow a trader to have a better idea, and help them to make consistent profits, which we’ll talk about later on.
So there we go. In FX terminology, we have just been trading the Euro / US Dollar - EUR/USD. And since currencies are bought and sold against each other, they’re always traded as pairs, and hence the notation of Eur/Usd, Gbp/Usd, Eur/Gbp, etc… The holiday example I used above is a very simplistic example. Usually the bureau-de-change will charge you a small fee when you exchange currencies. After all, they are providing you a service, so they’d also want their small bit as well. This small fee is also known as the “spread” and/or “commission”.