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Lesson 8: How money is made in Forex trading
Think of Forex as a global marketplace where currencies are traded like goods. Just as you exchange money when traveling, in Forex, you trade currencies hoping their value changes in your favor. If you buy euros with dollars (EUR/USD) and the euro strengthens, you can sell it back for more dollars, pocketing the difference as profit. Forex trading is about buying and selling currencies. You make money if the currency you buy goes up in value compared to the currency you sold, or if the currency you sold goes down in value compared to the currency you bought. This can happen in any currency pair, like EUR/USD or NZD/USD.
Buy Low, Sell High: If you anticipate the euro will increase against the dollar, you buy EUR/USD. If the euro strengthens, selling it back at a higher price means you've made a profit.
Sell High, Buy Low: Conversely, if you predict the euro will weaken, you can sell EUR/USD. If it falls, buying it back at a lower rate results in a gain.
'Pips' and Profit Margins
What is a Pip? A pip is the smallest price move in a currency pair. For instance, if AUD/USD moves from 0.8500 to 0.8700, it has moved 200 pips. If you sell at this higher price, you gain 200 pips. But if the price continues to rise after you sell, you miss out on additional gains - this is known as opportunity loss.
The Zero-Sum Nature of Forex
In Forex, one trader's gain is often another's loss. For example, if you buy AUD/USD and it increases in value, you earn a profit (measured in pips). The person who sold AUD/USD to you may have a loss unless they had bought it even cheaper earlier.
What Does 'Short Selling' Mean? It involves selling a currency pair, like USD/JPY, expecting it to decrease in value. Later, you buy it back at a lower price, profiting from the difference. Short selling in Forex doesn't carry the negative connotation it does in stock trading. In Forex, every trade is essentially both a buy and a sell.
Currency Pairs and Their Unique Traits
Each currency pair has unique behaviors and reacts differently to economic events. For example, the Australian Dollar (AUD) might rise due to its yield advantage over other currencies, while the British Pound (Sterling) might react sharply to changes in the UK's economic outlook.
Market Dynamics
Forex markets are dynamic. Some traders prefer quick trades to capitalize on short-term fluctuations, while others adopt a longer-term approach. In stock markets, shorting is often seen negatively, as it's based on the belief that a stock’s price will fall. This is different in Forex, where trading involves both buying and selling currencies simultaneously, and there's no inherent bias towards either.
Staying Ahead with Information
Economic news, political events, and central bank decisions can significantly impact currency values. Forex markets can change rapidly, which makes trading challenging. This volatility often leads traders to prefer short-term trades, even though long-term trends might suggest holding positions for longer periods. Economic data, central bank policies, and global events can heavily influence currency values. Traders often analyze these factors to make informed decisions.
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