Let’s look at the exact same example, only now Sarah decided to wait 4 months to finally book the hotel in Italy. In that time, she didn’t notice that there had been a strong upward movement in the value of EUR due to strong growth in Europe. As a result, the appreciation of EUR against AUD has jumped up to 1.79 EUR/AUD.

Sarah again goes online to pay for the booking, however while the price hasn’t changed in euros (€750), when selecting to pay in AUD, the price is now $1,342.50 (€750 x 1.79). Waiting four months is now costing Sarah $172.50 more. Noting, had an event such as the Australian economy strengthening occurred, the opposite may have happened and Sarah would have saved money!

Movements like these are what traders look for in order to make money from the fluctuating currency prices. 

 

Profiting from FX movements

 

 

Traders uses movements in the exchange rate to try predict which direction the market is going to go. Technology and software have allowed even the retail trader to access the markets through broker platforms. Speculate for profit using derivatives WITHOUT having to physically buy, hold and sell any currency is now easy.

These movements can be very sudden or quite gradual. FX has a strong reputation for having the most volatile (rapidly changing) movements and this is what makes it so attractive to traders. It can be a short time before a large movement occurs, allowing a trader to capture significant gains (or be at risk to significant losses).

Like any market, the laws of economic supply and demand determine the value. For example, if an economy is looking strong and investing money in that country will provide a larger return, foreign investors will be eager to put their money here. This is known as foreign direct investment. First, they will need to buy that currency to transact – and here lies the exchange. If more people begin trying to buy the more desirable currency, this will push up the value just like when investors buy shares in a company.

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Therefore buying one currency against another, waiting until that currency is stronger, and then buying back the original currency makes you profit. Let’s look at the simplified example below:

Andy is a trader with $100,000 USD in his hands and he notices that the current rate is GBP/USD = 2.0000 (1 pound buys 2 dollars). Based on current market analysis, Andy believes the GBP will be even stronger against the USD in 5 days’ time. He then decides to exchange $100,000 USD and buy £50,000 GBP ($100,000 / 2.0000).

 

• 5 days later Andy was right, the GBP strengthened. Now the GBP/USD is worth 2.1000 (A move this large is not often seen in such a short time).

• Happy with the movement, Andy decides to exchange the £50,000 back into USD, now at a rate of 2.1 instead of 2.0.

• £50,000 x 2.1 = $105,000 USD

• In 5 days’ time, Andy has made $5,000 by 'predicting' the direction of the market.

 

Different tools to trade forex

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Traders most commonly use the following financial instruments to profit and speculate on the FX market. Each has advantages and disadvantages such as differences in liquidity, transparency and costs.

 

• Spot market: Currencies traded instantly and on the spot using the current market price. Spot transactions will settle within two business/trading days.

• Forward & swap market: A contract exists to buy/sell an amount of the currency at a future date (longer than two business days) for a pre-determined rate.

• Options market: Contract in place to buy/sell an amount of currency at a specified price up to an expiry date. The contract gives the buyer the right or the ‘option’ to use this contract if the market price moves in their favour. A premium is therefore paid for this choice whether to use the contract or not.

• Exchange-Traded Funds (ETF’s): A fund which can contain a number of products such as currencies, stocks and the like allowing a trader to diversify.

Understanding the 'buy' or 'sell' of a currency pair is one of the first steps. If you expect the GBP rise in value against the USD, then you would BUY GBP/USD. The pound is the ‘base’ currency and you are buying pounds (the currency on the left) assuming it will rise against the dollar. 

Alternatively, if you felt the USD would rise against the GBP, look to SELL the GBP/USD currency pair (sell pound for U.S. dollars). 

We look at the ‘base’ currency to be the ‘basis’ on which we buy or sell against the other currency. Following topics will cover important terminology to ensure this makes more sense and how to read the currency pairs.