The daily trading volume of currency trading is a little bit over $3.2 trillion making forex trading the largest market in the world. Even compared to the New York Stock Exchange (NYSE), which is the stock exchange with the largest daily turnover reaching nearly $50 billion, the currency trading market is largest by far.

A currency’s value is always estimated in relation to other currencies. What forex trading does is to leverage the fluctuations in a currency’s relative value based on the purchase and sale of large quantities of currency around the globe.

The spot rates are the rates paid for delivery of a currency on the spot, which in real terms cannot be more than two days after the day of trade. It is also possible to buy or sell currencies for delivery at some agreed-upon future date, typically one to three months from the day the transaction is negotiated and this is the exchange forward rate. Typically, the amount of currency trading is one lot, which is equal to 100,000 of currency value.

Example of forex trading

To illustrate how forex trading works, we assume that the current bid-ask price for EUR/USD is 1.0115/1.0120, meaning 1€ (EUR) costs $1.0120 US dollars (USD). If investors feel that the euro is undervalued against the dollar, they would buy euros and sell dollars waiting for the exchange rate to rise. The trade would be buy 100,000€ and sell $101,260.

Now, we assume that EUR/USD rises to 1.0230. Since investors bought euros and sold dollars, they should sell euros for dollars to realize any profit. So, investors sell the 100,000€ at the current EUR/USD rate of 1.0230, receiving $102,360. Since originally they sold $101,260, the realized profit is $1,100 ($102,360 – $101,260).

Now, assuming that the EUR/USD had fallen by the same amount, investors would have suffered a loss of $1,100 instead of a profit.

Investors prefer currency trading because the spreads are extremely low thus lowering the cost of the trade. Also, the volatility is extremely high and this may offer to investor enormous gains from one trade. To get an idea, the volatility over spread ratio for the forex trading market is 500:1, while the best stocks have 100:1. The main reason that the relative value of currencies fluctuate is because it is subject to conversion very often. Importers, exporters, tourists and governments buy and sell currencies in the foreign exchange market. Another reason is that investors speculate the future movement for a currency and they buy or sell accordingly. Speculation typically has radical consequences on a national currency and consequently on a country’s economy.

Investors who favour currency trading typically avoid emotional trading. They set their original plan and they do not deviate from it. They are able to assess unfavourable swings and exit the market, but they base their strategy on market realities and not on gut feelings. Moreover, they follow the market trend and they apply strategies they understand how they work and, most importantly, what are the risks and benefits involved.

In reality, foreign exchange market is mostly open to bank conglomerates and large multinationals. However, ground-breaking technological advancements made it possible for individual investors to reap the harvest of forex trading. The only thing individual investors should keep in mind is that, if you cannot afford to lose, you cannot afford to win either.