Your mission as a Forex trader (should you choose to accept it) is to earn as many pips as you possibly can. The more pips you earn in currency trading the larger your profits will be. So, what is a pip and why does earning them help you make money in Forex?
The basic goal of Forex trading is to swap one currency for another currency then cross your fingers and hope the currency you bought will increase in value relative to the one you sold. Then once it increases in value you sell it back in order to receive more of your original currency in exchange.
It’s your old favorite investment cliché of buy low and sell high. However, there are many ways to accomplish this with Forex trading. Let’s explore a few examples to help you better understand how to make money in Forex.
Pick a Pair
Before we dive into the ways a Forex trader makes money, it is important to understand how a currency pair works. You’ve probably heard of an exchange rate before – news anchors and travel agents often talk about favorable exchange rates.
Well, what is an exchange rate? It is purely the value of one currency in relationship to another. In other words it is the amount of Euros that a Dollar can buy or the amount of Dollars that a Euro can buy.
Since exchange rates pit one currency against another they are quoted in currency pairs. If you wanted to know how many Euros it would take to buy one Dollar then you would check the USD/EUR exchange rate.
The first currency listed is known as the base currency and the second is known as the counter or quote currency. The exchange rate will tell you how many units of the counter currency it will take to buy one unit of the base currency and vice versa.
Theory of Relativity
Remember when you were a kid and traded baseball cards with your friends? Let’s imagine that it’s 1998 and you are engaging in some hardnosed negotiations with Tommy, the local seventh grade card kingpin.
You trade Tommy one of your Mark McGwire cards for one of his Sammy Sosa cards. Sosa then hits homerun number 66 and you hurry over to Tommy’s house and trade him your Sosa back for two Mark McGwires (of course McGwire goes on to beat Sosa in the homerun race and if you’re smart you trade McGwire for as many Barry Bonds as possible…)
Forex trading is very similar to baseball cards – except that your broker doesn’t usually include bubblegum in a currency lot. Let’s evolve our baseball card example by substituting currency for cards and increasing the quantity:
Say you start with 1,000 U.S. Dollars (USD) and wish to purchase Japanese Yen (JPY) because you think the JPY will increase in value relative to the USD, just like why we originally traded the McGwire for the Sosa. So, if the JPY/USD exchange rate is 0.0075 (meaning that each yen will buy a very small percentage of each dollar) then you start off by purchasing approximately 133,333 JPY with your 1,000 USD.
You then hold onto your JPY for 2 weeks at which time your instincts prove correct because the U.S. president announces the U.S. is heading towards a recession and the value of the dollar plummets. With this news the JPY/USD exchange rate rises to 1.000 (1 JPY now equals 1 USD). You then buy 133,333 USD back with your 133,333 JPY, resulting in a profit of about 132,333 USD.
This example is a bit extreme and currency values do not usually change that drastically in a two week period, but hopefully you’re beginning to see how money can be made in Forex trading.
The Long and Short of It
There are several ways for you to make money on a Forex trade depending on whether you want to buy or sell the currency that is currently in your possession. In the example above we decided to buy JPY with the USD we had. In Forex speak we went long on the JPY/USD.
Suppose you had started off with JPY instead of USD and decided to sell your JPY for USD in anticipation that the JPY would decrease in value. Your strategy here would enable you to buy more JPY back once the price dropped. Executing your trades in this manner is considered going short on the JPY/USD.
Going short or long in Forex is just an insider’s way of saying whether you bought or sold a particular currency as part of your strategic move to make a profit. Just remember that long equates to buying and short equates to selling.
Buddy, Can You Spare a Pip?
In the introduction to this article we told you that your goal was to earn pips. So, what is a pip? Well, it’s not a character on South Park or the star of a Charles Dickens’ novel (just in case you were wondering).
Put simply, a pip is the smallest price change that a given exchange rate can make. Most major currency pairs are priced to four decimal points, so the smallest change for most exchange rates is equal to a 1/100th of one percent.
Your profits and losses can be calculated in terms of how many pips you gained or loss. A pip is derived by comparing the starting rate to the ending rate. The difference between the two is how many pips you gained or lost.
For example, if the exchange rate for the USD/CHF was initially 1.2155 and rose to 1.2159 then it has moved 4 pips – which could be good or bad depending on whether you own Francs or Dollars.
Putting It All Together
You should now have a better understanding of how you can actually make money as a successful Forex trader. Remember, Forex trading is NOT easy – anyone who tells you otherwise is lying.
Carefully prepare yourself and learn all you can before trying to execute any trades with real money. Once you feel comfortable then go out there and get all the pips you can!
Next: Forex vs. Stocks