Profiting from Currency fluctuations

The best way to understand how Forex trading works, is to consider some long-term currency changes and try to understand the driving force behind each change.

If we look at the relationship between the US Dollar (USD) and the UK Pound (GBP) on 30th November for the years between 2004 and 2006, you find the following pattern:

Year USD GBP
2004 1.91 1.00
2005 1.73 1.00
2006 1.97 1.00

If you had purchased £1000 UK pounds on 30th November 2005 using US dollars as your buying currency you would have spent $1730 and recieved £1000 in exchange. If you then held onto your £1000 for one year and sold them on the 30th November 2006 for US dollars you would have received $1970. In effect you would have increased your return by $240 which is a growth of 13.8% on your original investment.

Although 13.8% return on your investment will not let you retire in Hawaii it's a much greater return than you'd expect to recieve from leaving the money in your bank account.

Wha would have happened if you made your purchase of £100 on 30th November 2004?

You would have spend $1910 to buy £1000 on 30th November 2004. If you then went on to sell your holding of £1000 on 30th November 2005 you would only have recieved $1730. You would therefore have lost $180. This equates to a net loss of 9.4% on this transaction.

The illustration above shows you how you profit from currency trading. In order to profi you need to buy foreign currency at one price and wait until it has signficantly increased in value and then move to sell your holding. It also highlights the risks of Forex trading, when the currency that you have purchased, on the basis that you believe it is going to rise in value, drops in value and you make sometimes a significant loss on the trade. The size of your loss will of course depend on the magnitude of your exposure to the currency.

The difference between the example and real-life currency trading is the length of period for which you hold a particular currency.  You would not typically hold a currency for anywhere near the months and years in the illustration above. You would more typically buy and sell within a single day and at a maximum of 7 days. This is because Forex trading involves small short-term changes in currency value, which are typically a fraction of a percentage point. These short-term changes take place all the time and typically are evident within a few hours.

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