Forex trading involves trading foreign currencies against each other as some strengthen and others weaken. It's an advanced strategy that requires upfront research and some understanding of how currencies work.
Tutorial: Forex Trading
The Basics of Forex Trading
When engaging in forex trading, you are simultaneously purchasing one currency and selling another. For example, if you purchased Japanese yen and sold U.S. dollars, you would be going long JPY/USD. Over time, the foreign exchange rate of the yen compared to the dollar will change. When you close out the trade, you will have either a gain or a loss when you sell yen and purchase dollars.
When you open the trade, 100,000 yen may cost you $1,300. If the dollar weakens, your trade is worth more over time. When you close the trade, you will sell the 100,000 yen for more that you bought it for. It may be worth $1,400 and you will have made a gain of $100 on the trade. Most currencies can be traded on established forex markets, but the U.S. dollar, the euro and the yen are the most commonly traded. (Currencies can provide diversification for a portfolio that's in a rut. To find out which ones you need to know, see Top 8 Most Tradable Currencies.
Forex trades are conducted through brokerages. Many brokerages have an online trading platform. When you place an order on your account through the broker, the trading house sends the order to the Interbank Market to fill. The Interbank isn't a bricks and mortar establishment, but a network of traders and banks that deal in currencies.
As with stock brokerage houses, some forex brokers offer guidance and advice with trading and others leave you to trade on your own. The costs and fees to maintain an account and to conduct each trade vary from broker to broker. Popular brokers include CFOS/FX, ForeFront Forex and Infinity Brokerage Services. (If you're a rookie investor, your first big investment decision should be an informed one. For advice, check out Picking Your First Broker.)
Trading on Volatility
This year is a particularly volatile time for forex trading, which can mean larger gains and larger losses. The United States and many European countries are facing unprecedented budget crises, political instability and natural disasters. All of these factors will have an impact on the value of currencies and their relationship to each other. The continued strengthening of the yen against most other major currencies makes it a good bet in the short to medium term and JPY/USD trades are popular.
Dangers to Avoid
While making gains on forex trades is the reason investors get into the game, losses are always possible. Currencies are particularly susceptible to swings due to major events - most of which are unpredictable. An unexpectedly negative jobs report, a major earthquake or the death of a foreign leader can all lead to large and immediate downward currency movements. Losses can mount in minutes if you are on the wrong side of the trade.
The best way to avoid this type of devastation in your forex portfolio is to put a stop loss on every trade. A stop loss is a point at which your broker will automatically unwind your trade. It limits your losses when there are sudden swings and protects your capital investment. If you are gaining on trades, you can always set the stop loss point higher to lock in some of the gains. (For more read The Stop-Loss Order - Make Sure You Use It.)
The Bottom Line
Forex trading can be exciting, whether you day trade it or stay in for the long haul. Dealing with a reputable brokerage can mean the difference between making money and losing it. With the expected continued world volatility in the near future, there is a lot of money to be made in the forex market. (For a complete guide on forex trading tips, check out Forex Trading Rules.)