Why would anyone want to get into Forex trading with the markets set the way they are? The primary reason is that most investors are spooked, and getting a basket of currencies means that, unlike stocks, it’s unlikely that a market turn will devalue them to nothing. They’re still currencies – and if they’re going to devalue down to nothing, there’ll be a significant warning in the news.
What follows is a primer – the very basics of what forex trading is, and how it works. It’s designed to give you enough information to make informed decisions; it’s not enough to let you go in on your own, but should help you recognize terms and understand what’s going on when someone else tries to give you technical information.

The way forex trading works is by working the price differences that two currencies (called a currency pair) would have. For example, if the Euro were trading at $1.63, that means that each Euro that you buy costs you $1.63 US. If it later rose to $1.65, and you sold it, you’d make a profit of 2 cents for every Euro you bought. This doesn’t seem like much – less than 1/80th. However, that’s the margin per trade done, and it can add up (or if you guess wrong, drop) fast.

Professional currency traders use an instrument called leverage. Instead of buying those currencies with their own money, they take out a short term loan and buy large amounts of currency with it, hoping that the shift in currency prices will allow them to pay off the loan and interest, while still making a substantial profit. Let’s assume that you’ve got a loan at 10% per year, and you have $2,000 of your own money. You can use that money to buy 1,227 Euros directly at $1.63 each. When you sell them at 1.65 at the end of the day, you get your $2,000 back, and a profit of about $24.55 (1,227 * 1.65 = 2,024.55).

Now, let’s say that you use that loan to buy $10,000 worth of Euros, and it’s payable at 10% per year. That means that each day the loan is out, you’ll be charged 1/365th of $1,000, or about $2.75. You use the $10,000 to buy Euros at $1.63, sell them at $1.65 the next day, and your final profit looks like this:

$12,000 (your $2,000 original stake, plus $10,000 in loans)/1.63=7,369 Euros. If you sell them at $1.65 the next day, you get $12,147.23 back. Minus the $10,002.75 you owe the person you borrowed the money from, this gives you back $2,144.50, or a profit of $144.50 on your trade.

The more leverage you can swing, the more you can profit off of a small variance in currency prices.

That’s the ideal case for trying to day trade forex markets. And it’s what everyone out there will try to sell you on. Now, let’s inject a dose of reality. First, day trading relies on you being able to ‘outguess’ the market at key times during the day; unfortunately those key times during the day are when the London market opens, the London market closes, the New York market opening and closing, and the Hong Kong market opening and closing. What this really means is that if you’re going to be doing day trading, you’re going to be staring at numbers on a screen at all hours of the day and night, and this will become a job. If it’s not a job you enjoy, you’re going to hate it. It’s stressful, you run the risk of losing money hand over fist, and there will always be people who claim they can automate it and will sell you the secret. (Trust me – anyone who could automate this wouldn’t be selling the secret. They’d be using it to become the richest person in the world in about three weeks and then retire.)

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There is a better way to work the forex markets. It’s called position trading. Just like there are daily volatility trends (currency prices drop when the London market closes and everyone sells off), there are also weekly and monthly trends. Weekly and monthly trends are also equally valuable, and while you won’t make as many trades in a day (and make as much money), you will have the ability to live a decadent life where you can go to the bathroom without watching your Blackberry. You might even be able to let your investments sit and grow.

Position trading, unlike day trading, usually doesn’t require that you apply large amounts of leverage to make trades. It’s thus a lot less risky to get into and toe try and see if this is a kind of commodities or futures trading process that you can live with.

Another strategy you can do while doing position trading is buying certificates of deposit or investing in foreign money market funds, letting your initial investment earn interest while waiting for the right conditions to sell off.

Standard practices on position trading include watching when countries traditionally take their vacation times – this usually results in a drop in currency prices (because they’re converting currencies for travel), making it a prime buying opportunity. In roughly three weeks, there will be a prime selling time as those vacationers sell off the currencies they bought to their home currency.

Other trend lines to watch for either kind of forex trading are news items covering inflation. Inflationary pressure on a currency means that it’s going to drop in relative purchasing power; this is usually an opportunity to sell short, or to play a waiting game to buy a currency when it’s down cheap. Regrettably, the US government is sending strong inflationary signals right now; while that’s bad for the overall economy, it does mean that doing position trading against the dollar is a wise strategy at this time.

With luck, this primer will give you the information you need to understand more technical information on currency trading and forex materials in general. Forex trading, like stock trading, is a job. It’s not an “automatic road to making millions”, but it is a sound, sensible and rational investment opportunity if approached carefully.