How Forex Trading Works

Investors who want to invest in avenues that yield returns at relatively less risk are plenty, yet there are some options where the returns outweigh the risks and one such option is Forex trading. The variation in price of currency exchange rates enable investors to trade foreign currencies in the Forex market. Here, we try to explain how Forex trading works and the nuisances of the mechanism involved.
The word Forex is an abbreviation of 'Foreign Exchange' or it sometimes simply known as FX. This kind of market is a non-central, worldwide, over-the-counter market where currencies can be swapped and traded for corresponding prescribed values of trade. Forex trading essentially involves conversion of currencies at a certain specified exchange rate. The Forex market is one of the most complicated market as, lets face it, it consists of all currencies and indirectly all the national economies in the world.

Forex Trading Mechanism

The primary mechanism of Forex trade is as simple as a child's play. Every currency has a specified exchange rate which is chiefly used to convert it into a different currency. For example, a single US dollar can be exchanged into 0.702395168 Euro. This currency pair becomes the USD/EUR currency exchange pair. Though the actual transaction is in reference to a conversion, it referred to as the purchase of the 'Euro'. In this pair of currency, the currency which has been used to purchase is known as the base currency, whereas the currency which has been converted into or has been purchased is known as the quote currency.

So how does this process actually materialize? As mentioned above this market is a worldwide market which is open throughout the day i.e. from 20:15 GMT (Greenwich Mean Time) on Sunday to 22:00 GMT of the immediate following Friday. Any person can invest into this market through a licensed broker, who charges commission for trades. Note that the legal systems and governing bodies such as the United States Securities and Exchange Commission often tend to impose certain governance and compliance on the trade processes, which people need to adhere to.

How to Make Profit?

So, how is profit made through the trades of the Forex? Every currency irrespective of the nation and the economy of the nation is influenced by two universal economic dissertations or corollaries:
  • The currency value of any certain economy, tends to be influenced by the performance and growth of the economy, with respect the base currency.
  • Similarly, the exports, development, disasters, internal banking, companies and other such countless features, which even include, wars and terror attacks, substantially affect the value of quote currency with respect to the base currency.
Now, both the aforementioned conditions tend to affect the values of both the base and quote currency. In this kind of situation you can make profit with the help of measures, namely:
  • After you invest into the quote currency, you can wait for the quote currency's market value to raise, which increases your purchasing power to buy some other currency or re-buy your original base currency. So basically just by investing into well rising economy you are at position with higher currency value.
  • The second type of measure which you can initiate is to wait till the value of your base currency drops down. Thus you shall be able to easily have a greater purchase value as you reconvert back into the base currency. In this measure, however you would not be able to convert your quote currency into any other currency than your base, as it may be either a situation of loss or a no-profit-no-loss situation.
Measurement of Profit or Loss

In this mechanism of Forex trade, one very big problem is that the Forex trade is characterized by the conversion of currencies, which is basically a barter. Hence there is no uniform way to measure profit or loss. In such a situation, the concept of PIP and BP is used.
  • PIP or Price Interest Point is the one unit change in the decimals of your base currency for example a change in USD $0.0001 (increase in cent) is known as 'one pip'. When one pip of the quote currency increases, you are at a profit of one pip. On the other hand if the base currency decreases by one pip, then you are still at an advantage.
  • The BP or the Base point is the per unit increase in non decimal value (dollars). For example, a change of $1.0000 in your base currency is the change in Base Point.
The formula to figure out the actual profit goes as:

PIP or BP / Current Exchange Rate = PIP or BP Value

The 'PIP' or 'BP' value is the currency actual currency value such as dollars and cents. The 'PIP' or 'BP' is expressed in percentage or units.

Now all these calculations and conversions are usually done by automated software, some of which in some cases also alert you about PIP changes.