How Do Forex Traders Make Money

Foreign exchange trading can be confusing—to make money, people buy and sell money on the forex markets. But how does this transaction happen, and how can you profit from buying and selling currencies on the exchange?

Making Money in Forex
When you buy one currency, you are essentially selling another—that’s the idea, anyway. To buy a forex pair is to say that you think one currency will rise in value against another. If you were to buy the GBP/JPY pair, for example, you would be betting that the Pound will rise in value against the Yen. This can happen if the Great British Pound rises and the Yen falls, or if the GBP falls less than the Yen, or if the GBP and JPY both rise, but GBP rises by a greater amount against world currencies.

Making money in forex is limited to two ways: making money on interest rates, or making money on currency fluctuations. Currency fluctuations are market movements that happen when the price of one currency rises or falls against another. Interest rate trading, however, can produce profits without a change in currency prices. Instead, investors seek to borrow in currencies that are inexpensive to borrow and invest overseas in countries that are paying high rates of interest for investment capital.

In the long-run, currencies rise and fall based on a number of factors:

Economic growth – Buying a currency is like investing in an entire country. If the country in which you purchase currency is experiencing economic growth, then it is likely that their currency will rise in value against other currencies, as well. This has mostly to do with the fact that a strong economy is a driving force behind the purchase of government debt, and governments find more buyers for their debt when their economies are growing.

Low inflation – Low inflation rates relative to the growth rate show that the supply of currency may be too low. If the inflation rate is 1% and the growth rate is 10%, for example, then it is likely that the government will enforce policies to allow the growth rate to come closer to the inflation rate. Doing so usually includes buying back currency to create a temporarily more valuable currency and a slightly slower growth rate. While high-growth is good, it often sets up the possibility of speculative bubbles, which central banks usually seek to avoid.

Interest rates – High interest rates usually incite investment interest in a particular currency. The Australian dollar, for example, has followed this trend for a long time—the country tends to seek out higher rates of interest to attract foreign investment. As such, investors like to borrow in one country and lend to Australia. This is done by selling one currency against the Aussie Dollar or buying the Aussie dollar against another currency. In the case of the EURAUD, the investors who short it would be borrowing in Euro and lending in Australian dollars, which creates a trade known as a “carry trade.”

Commodity prices – Rising commodity prices are a boon for countries like Canada, which exports millions of barrels of oil to the rest of the world. When commodity prices rise, the Canadian economy brings in plenty of activity, and everyone from oil buyers to speculators buy Canadian dollars to do more business with Canadian exporters. The same is also true for Australia. Since Australia is a major commodity producer, the country tends to see rising currency values with each rise in commodity values.

In the short-run, currency prices are largely dependent on basic supply and demand. While the markets may move by 100 pips or more each trading day, the actual movement in percentage terms is often less than one-percent. One percent moves, though common, aren’t necessarily where the most money is made, and are often set off by a series of non-speculative currency transactions.

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