How to Make Money by Trading Money
One of the concepts that many forex traders often have trouble grasping is that of currency pairs. How do they work, and how do you profit from them?
In order tounderstand how Forex trading works exactly, let us look at a typical currency pair the USD/JPY. The currency on the left is the base and the one on the right is the quote. The base is always worth one unit and the quote the amount of that currency you can buy with one unit of the base. To express this in numerical terms 1:122.85, meaning you can buy 122.85 yen with one dollar.
What you are doing when you are trading a currency pair is that you are buying one currency while selling the other. To illustrate, when you are buying the USD/JPY currency pair, what you are actually doing is using US dollars to buy Japanese yen. You make your money by doing the reverse, namely selling the yen in exchange for dollars.
Numerically, this is what the transaction looks like. Lets say you used $10,000 to buyJapanese yen. At the current exchange rate you received 1,228,500 yen. Now, lets say the dollar strengthened against the yen and the exchange rate appreciated to 122.75. You sell your yen at the new rate and you get back $10,0008. You thus enjoyed a profit of $8 on the transaction.
If this rate of profit seems low to you, thats why most forex traders use leverage. Leverage essentially means trading with money borrowed from your broker to increase your rate of return. The money that you borrowed is referred to as the margin. For example, if your broker extends you leverage of 1:100, you can use the same $10,000 in your trading account to buy $1,000,000 worth of yen or 122,850,000 yen. Thus, your profit for the transaction then becomes $814.
Of course, using leverage also carries risks with it. For example, if the euro weakens against the dollar and the exchange rate falls to 1.0732, then your loss is $1,000. If there is not enough money in your trading account to cover it, then you may be subject to the dreaded margin call, in which you are required to deposit more money into your account to meet the required margin or else risk your positions being closed.
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