In the stock market, you make money by buying and selling stocks. In the real estate market, you make money buying and selling real estate. In the forex market you make money by buying and selling currencies … buying and selling money, the currencies of other countries.
Here’s an example:
Let’s say you believe that the Euro will become stronger against the US Dollar. So you go down the the foreign exchange office at the closest international airport and convert $10,000 dollars to Euros at the rate of one dollar to €1.25 Euros. So you now have 8,000 Euros and, as it turns out, you were right! Thirty days later, the Euro is valued at €1.35 to $1.00 and you convert your 8,000 Euros back to US dollars. You now have $10,800 in US dollars … an $800 profit.
It works whether you go long (expecting the other currency to rise) or go short (expecting the other currency to fall).
Is forex trading easy?
It’s rarely that easy, though. Forex trading is fraught with idiosyncrasies that are unique to its market and most currencies are traded on margin … borrowed money. Proponents of Forex trading trumpet the fact that you can “control” hundreds of thousands of dollars (or euros or yen or pounds sterling) for just a few thousand dollars. You don’t “control” anything, you’re just responsible to cough up the dough should you begin to lose money (a common problem in forex trading).
Since such a small amount of money can allow you to purchase/control a HUGE amount of currency, the potential for making a large amount of money is definitely there, as is the potential for large losses. At an exchange rate of $1.50 (USD) to one British pound (GBP) and a margin requirement of 2%, you can “control” 100,000 pounds with only $3,000. Should the exchange rate increase in value to 1.51, you’ll make $1,000. Should it decrease to 1.47, you’ve lost your entire $3,000. Such daily swings are feasible.
About forex rollover charges
Why mention the daily swing? Because you’re charged interest, too. Since every currency trade involves borrowing one currency to buy another, interest charges are part of forex trading. This interest charge is called “rollover.” Since currency trades are always conducted in pairs (a base currency or what you’re buying and a quote currency or what you’re using to purchase the other currency), interest is paid on the currency that is borrowed, and earned on the one that is bought.
If you are buying a currency with a higher interest rate than the one you are borrowing, then the net interest rate differential will be positive (i.e. USD/JPY) and you will earn additional cash as a result. But, if the interest rate differential is negative then you will have to pay interest.
This interest is charged daily and brokers have cut-off times (usually 5:00pm Eastern).
Example: if you buy a currency with a rate of 4.5% with a currency having a rate of 3.5%, you make extra money should you hold the trade past 5:00pm EST. It works the other direction as well.
Should you invest in forex trading?
Probably not. Unless you have cash you’re willing to risk and the time and wherewithal to learn the ins-and-outs of forex trading, you should probably stick to another investment vehicle.