Chapter 9. Forex and Currency Exchange

The goal of trading on Forex is to earn money through currency speculation. So far, we have discussed the forex market extensively. However, we have yet to address questions such as the initial capital required for Forex trading and the potential profits one can expect. In this chapter, we will try to clarify these aspects.

Since currency exchange at an exchange office serves as a simplified model of earning money on Forex, let's start by considering it. Theoretically, it is possible to generate profits from buying and selling currency at an exchange office. However, as we will see throughout this chapter, the magnitude of such profits is negligible compared to the earning potential of online Forex trading.

Let's imagine that we have $1,000 US dollars, and we want to earn money through currency speculation at an exchange office. Suppose the exchange rate of the US dollar to the Japanese Yen at the exchange office is USD/JPY 104.15/106.65. We anticipate an increase in the exchange rate of the Japanese Yen against the US dollar, so we decide to buy Japanese Yen with all our available dollars. From previous chapters, we know that the bid/ask prices refer to the base currency of the quote, which, in this case, is the US dollar. In this context, we are selling dollars, and the exchange office is buying them. The buying rate (bid) is listed first in the quote, so we receive 104.15 * 1,000 = 104,150 Japanese Yen.

If we immediately sell our Japanese Yen back for US dollars at the specified quote, we would receive 104,150 / 106.65 = 976.56 dollars. This means that we would incur a loss in this transaction, and the amount of the loss would be 1,000 - 976.56 = 23.44 dollars. So, what do we need to make a profit? Clearly, the selling price in the USD/JPY quote needs to drop below the initial buying price. In other words, the selling price must decrease by more than 250 pips. Notice that 250 is the size of the spread in the quote, which means that the selling price must change by at least the spread value for us to at least recoup our initial investment of 1,000 US dollars.

The problem is that waiting for a currency exchange rate to move by 250 pips can take a considerable amount of time (weeks or months), depending on the current conditions in the Forex market. However, let's imagine that the exchange rate does change by a significant 500 pips in the direction we anticipated, making it USD/JPY 99.15/101.65. What profit would we make by selling our Japanese Yen? We would receive 104,150 / 101.65 = 1,024.59 US dollars. Our net profit from the transaction would be 1,024.59 - 1,000 = 24.59 US dollars.

In practice, waiting for a currency exchange rate to move by a significant 500 pips can take a long time. In this case, earning 24.59 US dollars can become our monthly or even quarterly income. Naturally, this is not the level of profit we would ideally like to achieve. However, you can rest assured that Forex trading works differently!

From the previous example, we learned an important lesson - the smaller the spread size in the offered quote, the more advantageous it is for you as a trader. In exchange offices, the spread can be hundreds of pips, and the quote itself is usually updated only once a day. On Forex, the spread size depends on the party providing you with the quote. For individual investors trading online, the spread size is determined by their internet broker (brokerage firm). Therefore, it is advisable to choose an internet broker who offers more favorable trading conditions. Depending on the traded currencies, the spread size typically ranges from 1 to 10 pips. However, as mentioned earlier, during periods of market instability, internet brokers may practice widening the spread, and it's important to be aware of this as well.

Another lesson we learned from the previous example is that in order to profit from currency speculation in an exchange office, we need to buy the currency with the intention of selling it at the right moment. In the case of the exchange office example, to buy Japanese Yen with US Dollars, we need to have the necessary amount in dollars. This is obvious, but Forex trading works a bit differently, and we will discuss that further. Another thing to note in the case of an exchange office is that for currency speculation, we only use the funds we have on hand. Of course, nothing stops us from going to a bank and taking out a loan, but no bank will give you a loan for currency trading speculation, and would you really want to risk losing a large portion of the loan and getting into debt? With Forex, things are simpler again. By using the principle of margin trading, which will be discussed in the next chapter, we can control capital that is hundreds of times larger than the funds we have, even with a relatively small capital (even a few thousand US dollars). The more capital we control, the more we can earn. After all, if we were buying Japanese Yen with not just $1,000 but, let's say, $100,000, we would have earned not just $24.59, but a whopping $2,459. And that is worth continuing to explore Forex, isn't it? So, let's conclude our discussion of the exchange office example and move on to the Forex market itself.

When trading Forex online, you need to choose an Internet broker (we'll simply refer to them as brokers for convenience). Your broker will open an account for you, to which you must transfer a certain amount of money called the margin deposit. The size of the margin deposit is both a philosophical and practical question. It depends on how aggressively you plan to trade, what leverage size you use (which will be discussed in the next chapter), how many lots you open simultaneously, your trading experience, and so on. For beginner traders, it is recommended to have a margin deposit of at least $1,500 to $2,000. The margin deposit is usually held in special multi-currency accounts that your broker opens for you at the bank they are affiliated with. Most internet brokers are offshore companies registered in offshore zones. Therefore, accounts are opened in US dollars, but this does not mean that you can only trade with dollar quotes. As an internet trader, you don't need to have pounds sterling on your account to buy Japanese Yen. This is the advantage of the Forex market - you can profit from currency rate differences without actual currency delivery, which means the settlement date loses its meaning. With US dollars in your margin deposit, you can execute trades with any other currency. Let's recall the example with the exchange office where we expected the Japanese Yen to rise against the US Dollar, or in other words, the USD/JPY exchange rate to fall. But what if we expected the US Dollar to rise against the Yen? It would be logical to buy US Dollars with Japanese Yen, but what if we only had $1,000 and no Yen? Obviously, we wouldn't be able to make such a transaction at the exchange office. However, when trading Forex online, traders can execute such trades because, as we mentioned before, there is no actual currency delivery. The money is earned solely through speculation, and the profit is converted into the currency of the margin deposit account, which is US dollars.

Indeed, the principle of earning remains the same - to execute a trade, we need to buy the currency at a lower price and sell it at a higher price. Alternatively, we can sell the currency at a higher price and buy it back at a lower price, which essentially means the same thing. After all, one currency is always bought or sold for another currency. The first stage of a Forex trade is called opening a position, and the second stage is called closing a position. At the moment of closing the position, the profit or loss from the trade is calculated, which is either credited or debited from the margin deposit. You can open a position by either buying or selling the base currency of the quote. If you open a position by buying the currency, it is called a long position. If you open a position by selling the currency, it is called a short position. For example, when someone says, "I have a long position on the US Dollar against the Japanese Yen," it means they have bought a certain amount of US Dollars with the expectation of an increase in the USD/JPY exchange rate.

The minimum trade size in Forex is called a lot. Its size is expressed in the quote currency but is typically equivalent to 100,000 US dollars. You open and close positions in the Forex market with a size that is always a whole number of lots. You may be wondering how individual investors can trade Forex when the minimum trade size is so large. Don't worry, the principle of margin trading, which will be discussed in the next chapter, allows you to control a capital of 100,000 US dollars while having only a few thousand dollars in your deposit, and risking only your deposit in the process.

But even margin trading doesn't help those who don't have such a sum. After all, some individuals have a relatively small amount of available capital (around a few thousand US dollars) but still want to trade Forex. For such investors, Internet brokers have introduced the concept of a mini lot, which is equivalent to 10,000 US dollars and can be easily controlled with a deposit of a thousand dollars. Some brokers even offer micro lots, with a size equivalent to just 1,000 US dollars, and to control it, only a few hundred dollars are required. However, micro lots are used less frequently. In practice, as a beginner Internet trader, you will most likely be working with mini lots.

It should be noted that the larger your deposit, the greater the number of lots you will be able to simultaneously hold open in Forex. Depending on the strategy that each trader develops for themselves, you may require several positions to be open simultaneously. This is something to consider when trading. Therefore, always monitor the size of your deposit.

To estimate the approximate profit from a single Forex trade, let's consider a scenario where we are trading with mini lots, have a deposit of $1,000, and anticipate an increase in the USD/JPY exchange rate. Assuming the current rate is USD/JPY 104.75/80, with a spread of just 5 pips, which is typical for Forex and significantly smaller than in the example with an exchange office.

Let's say we open a long position on the US dollar with one mini lot at a rate of 104.80 Japanese yen per dollar. Our forecast turns out to be correct, and at the time of closing the position, the USD/JPY rate is at 105.10/15. Thus, we managed to capture a favorable movement in the exchange rate of 30 pips (points).

To calculate the profit in US dollars, we need to convert the 30 pips into its dollar equivalent and multiply it by the size of a mini lot (10,000). To convert the pips to the dollar equivalent, we divide 0.30 by the selling rate of the US dollar against the Japanese yen, which is 0.30 / 105.15 = 0.0029. This value corresponds to 29 pips in dollar equivalent. By multiplying it by 10,000, we get the size of our profit, which is $29.

It is worth noting that in our example, the exchange rate movement was only 30 pips, and with our $1,000 deposit, we managed to make a profit of $29. In practice, such exchange rate movements can be captured on Forex within a few hours or even minutes.

In conclusion, let's compare the profits obtained from the operation in the exchange office described at the beginning of the chapter with the Forex operation described at the end. It is evident that the opportunities provided by Forex are incomparable to those of an exchange office. The profit that could be theoretically earned in a month in an exchange office can be earned in just one hour on Forex! Keep studying the material on the Forex Arena website, and soon you will learn how to make Forex trading a source of stable income for you.

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