How to make money and profit from currency changes – an overview of Forex

Let’s start by looking at a few long term currency changes; this will make it easier to understand how Forex work and how to trade using Forex.

Here’s a comparison of how the US dollar (USD) faired against the UK pound (GBP) on one day in November between ’04 and ‘06

2004 $ USD 1.91 £ GBP 1.00
2005 $ USD 1.73 £ GBP 1.00
2006 $ USD 1.97 £ GBP 1.00

So, if you’d bought £1000 on that day in November ’05 using your US dollars, the £1000 would have cost $1730, but what if you’d kept your £1,000 for a year instead? On the same day in November ’06, you could have bought $1,970 thereby making more on the deal; $240 more in fact which is a 13.8% return on the original investment. While that sort of return won’t make you wealthy overnight, it’s nonetheless a better return on alternative ‘safe’ investments.

Let’s now suppose you’d bought your £1000 on that November day in ’04, it would have cost you $1910. Selling your £1000 in November ’05 however would have meant that only got $1730, so you’d have effectively lost $180 which is a net loss equating to 9.4%.

These examples show us then how easy it is to use Forex to make a profit when trading currency; that is, you purchase your chosen currency, hang on to it until it’s value increases, then sell it on. However, where there’s a profit to be made, there’s also risk and we can see that with Forex, a drop in the value of the currency you purchased means a loss.

Furthermore, the examples given above show the basics of Forex currency trading however if you were to embark upon this form of trading currency, it’s unlikely that you’d retain your chosen currency for as long as months, much less years. Most Forex trading is completed on the same day of – or up to a week after - purchasing your foreign currency. This is primarily because most Forex trades involve relatively short term alterations in the value of currencies. This can be as small as hundredths of a percentage point and can take place within hours.

Now, let’s talk about the causes of alterations in currency values. Any currency’s value is determined by the inflation rate in the country it belongs to, which in turn, reflects that country’s general economy. Its value is then compared to the value of the currency with which you are making your purchase. We’re all aware that pretty much every country is subject to inflation which means that the value of currency in almost any country is likely to decline eventually. This can of course differ wildly depending on which country you’re talking about but if we assume we’re talking about countries such as theUSA,UK or other Western European countries, the rate of inflation is likely to be around 1 – 3% per annum.

In countries with less stability, for example, Zimbabwe, inflation may sky-rocket in a very short space of time. The Zimbabwean dollar – assuming an inflation rate of one thousand percent in one year – is worth less than 1/10th of its value in the previous year. The average cost of buying a loaf of bread inZimbabwe is one million Zimbabwean dollars!

That comparison made, even countries with a traditionally stable economy may find themselves in the grip of soaring inflation for a number of reasons. This then has an effect on the value of that country’s currency. A good example of this is the mortgage crisis in theUS in ’07 which saw record numbers of mortgages foreclosed. This, in addition to other economic factors, caused the value of the USD to fall by around 3%. The factors that affect the value of any country’s currency is called ‘Fundamental Analysis’ and it is always wise before investing in currency from any country to undertake this analysis and ask questions like ‘how stable is the government of this country’ and ‘is there any civil unrest or frequent periods of striking amongst its work-force’.