How Forex Trading Works, In Plain English

By: Ian Armstrong

The easiest way to illustrate how Forex trading works is to show some currency value fluctuations over the long term.

For instance, this list shows the difference in value of the US Dollar (USD) against the UK Pound (GBP) on Nov 30 your the years 2004, 2005 and 2006.

YearUSDGBP
20041.911.00
20051.731.00
20061.971.00

Now let's say that you bought 1,000 British Pounds (GBP) on November 30, 2005 with US currency. This would have cost $1,730. And if you held those Pounds for one year, then sold them on November 30, 2006, for US Dollars, you would have gotten $1,970 for those Pounds. This would have netted you a profit of $240, or 13.8% on your purchase of Pounds.

While not enough to make you rich, compare the rate of return here with nearly any other investment. This is a good rate of return by anyone's standards.

You can, of course, lose money in Forex trading, as in any sort of investment. For example, say you had bought those 1,000 GBP on November 30, 3004 instead and sold them on November 30, 2005. You would have gotten only $1,730 for your initial investment of $1,910. You would then have lost $180, or 9.4% on this particular trade.

As we see, you can make a profit with Forex trading if you buy a currency and sell it once it has increased in value. You can also end up taking a loss if you decide to sell after a drop in the value of the currency you are holding.

Of course, the above was just for the sake of example. When you are actually trading on the Forex market, you will be holding currencies for a much shorter time than in the example above. Most currency trades on the Forex market are done in less than a week. Forex traders work with small changes in currency values, generally hundredths of a percent. Most of this happens within the space of a few hours at most.

What Are The Causes Of Currency Changes?

Inflation is one of the prime causes both of currency value fluctuations, as well as the differing values of the currency of different nations. This difference can be seen as a measure of one country's inflation versus another's. Almost every country's currency is subject to the effects of inflation and thusly will decrease over time. In a country with a stable economy (generally speaking, these are Western democracies such as the US, Western Europe and Japan) there will be an annual rate of inflation somewhere between 1 and 3 percent.

Instable economies (usually found in non-democratic nations), inflation can be much higher. Zimbabwe is a prime example, with an annual rate of inflation more than 1000%! A loaf of bread, for instance costs around one million Zimbabwean dollars, and a Zimbabwean dollar is worth less than 10% of its value last year. A grim situation, certainly.

A stable economy can still experience runaway inflation at times. There are other things which can come into play to drive up the rate of inflation. The current situation in the U.S. involving sub-prime mortgages is a good example. The value of the U.S. Dollar has dropped by about 3% in the last year, largely as a result of the large number of foreclosures.

Fundamental analysis is the study of these sorts of factors which influence the economy of a nation - and it is a good thing for any Forex trader to have some familiarity with. Since you are in essence investing in these countries by purchasing their currencies, it is valuable to know whatever you can find out about their economies.

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