How The Forex Works
How You Profit From Currency Changes
In order to understand how Forex trades work it is easiest to look at some long-term currency changes.
The following list shows the relation between the U.S. Dollar (USD) and UK Pound (GBP) on November 30th for the years 2004 through 2006.
| Year | USD | GBP |
| 2004 | 1.91 | 1.00 |
| 2005 | 1.73 | 1.00 |
| 2006 | 1.97 | 1.00 |
Suppose you purchased 1,000 UK pounds (GBP), on November 30th, 2005 using U.S. Dollars. Your 1,000 GBP would have cost you $1,730. Now suppose you held on to your 1,000 GBP for exactly one year. And on November 30th, 2006 you sold your 1,000 GBP in exchange for U.S. dollars (i.e. you bought 1,000 GBP worth of U.S. dollars.) You would receive $1,970. In other words you would have earned $240 on the trade, that is a return of 13.8 percent on your investment.
Now 13.8 percent per year will not make you rich, but it is a whole lot better than the return on most "safe" investments.
However, if you had made your purchase of 1,000 GBP on November 30th, 2004, your 1,000 GBP would have cost you $1,910. If you had then sold your 1,000 GBP on November 30th, 2005, you would have received only $1,730. That is to say, you would have lost $180, i.e. you would have a net loss of 9.4 percent on the trade.
The above example shows how you can make a profit in Forex currency trading. That is you buy a foreign currency at one price, wait until it has increased in value, and then sell your holding of foreign currency. It also illustrates the risk in Forex trading, when the foreign currency that you expect to increase in value, falls in value instead, you make a loss on the trade.
The above example of Forex trading uses long-term currency movements to illustrate the basics of currency trading. When you start trading in the Forex for real, you are not going to hold on to your foreign currency for months or years. The vast majority of Forex trades are completed in a single day, up to 7 days at the most. This is because Forex trading involves very small short-term changes in relative currency values (typically of the order of hundredths of one percent). These short-term changes take place within a few hours.
What Are The Causes Of Currency Changes?
The value of Country-A's currency relative to that of Country-B is a measure of the inflation in the economy of Country-A versus that of Country-B. Almost all the world's economies are subject to inflation. That means the values of all the world's currencies decrease with time. In stable (democratic) economies such as the U.S., UK, western European countries, Japan etc. the rate of inflation is typically between 1 and 3 percent per year.
In countries with an unstable economy, (usually dictatorships) the inflation rate can be very much higher. For example the rate of inflation in Zimbabwe is over 1,000 percent per year. So one Zimbabwe dollar is worth less than one tenth of what it was a year ago, and a loaf of bread costs about a million Zimbabwe dollars.
Even in countries with stable economies, many factors can influence the inflation rate and hence the value of the currency. For example the sub-prime mortgage crisis in the U.S. in 2007, together with a record number of foreclosures has resulted in about 3 percent drop in the value of the U.S. dollar. The study of factors that influence a country’s currency value is called fundamental analysis. It is important to find out something about the countries whose currencies you intend to trade. For example: Do they have stable governments? Do they have a history of civil unrest? Are they subject to worker strikes?
