Forex 101

There is a lot of information to cover in the subject of Forex Trading. To ensure the information is presented in a way that helps you absorb it quickly, while still getting a solid, ‘big picture’ view of how Forex works for individual retail traders, I’m going to use a ‘building-block’ approach. We’ll start with the simplest example of currency exchange that most people are familiar with and move one step at a time to paint a picture of a single retail trade.

So, let’s begin with the transaction most people are familiar with - that of exchanging one currency for another when traveling overseas.

Imagine that you’re going on a trip to France. You have $1,000 U.S. dollars to spend on food, transportation, souvenirs and tours. You’re a smart traveler, though, so you don’t want to carry all of that $1,000 as cash in either currency.

Instead, you put $500 into traveler’s checks for safe keeping, and convert the remaining $500 into Euros (the Franc was replaced by the Euro at the formation of the European Union, of which France is a member).

On the actual day that you go to get your money converted, the foreign exchange rate is set at 1 US Dollar = 0.68679 Euro. This rate is the official, interbank rate for strict cash-to-cash conversions.

After you do the math, you see that your $500 in U.S. Dollars turns into a mere $343.397 Euro. Ouch! You’ve just taken a hit to the tune of $156.60 right off the bat in terms of buying power, even though you haven’t spent a cent.

What happened?

What’s happened is that the Euro was stronger than the Dollar at the time you made the exchange. Your Dollar wasn’t worth as much as the Euro. Therefore, you could not purchase 500 Euro with 500 Dollars.

Keep in mind, however, that this wouldn’t necessarily limit your buying power. How much you have to spend while in France depends on the cost of living. For example, if the equivalent of a $15 meal in the U.S. is only $12 in France, you may save enough to offset the hit you took on the exchange rate.

Now, remember that you’re a smart traveler. You keep up with the financial markets, and check the exchange rate each day of your trip. On the third day, you notice that the Dollar is continuing to weaken against the Euro.

You decide to go ahead and cash out your traveler’s checks before things get any worse, at a rate of 1 US Dollar = 0.67679 Euro. This gives you $338.395 additional Euro.

By the time your trip ends, you’ve spent most of the $343.39 you came with, but still have the $333.39 you converted from traveler’s checks. Let’s say you’ve got an even 400 Euro with you on the trip home, just to make things easy.

You put the money away when you get home, and keep watching the market. A few weeks go by.

Suddenly, the news reports that a major mid-east oil deal has rallied and strengthened the Dollar, bringing the exchange rate to: 1 US Dollar = 0.72679 Euro. Bingo! It’s time to dig those 400 Euro out of the sock drawer, and go buy back your Dollars.

After the exchange is done, you have $550.36. Don’t forget - you started off with $1,000 and lost $156.60 of it right off the bat, leaving you with the equivalent of $843.40. You spent $449.64 of that on your trip, so you should technically only have 393.76 left.

You don’t, though. You have $550.36 because the Euros you came home with bought back more dollars than you originally held.

This represents the simplest profit on an exchange of currencies, as well as the most elemental idea behind the Forex concept: buy low and sell high.

Now, while this example is representative, it is not entirely accurate. Real trades on the Forex market are often much more complex than this for anyone who wants to turn a serious profit.

Gains are made by trading far larger amounts of money, on far slimmer margins - and by exchanging multiple currencies at a time. The next posts will explain the concepts of Forex Trading.