How Forex Traders Make Money

In the online spot forex market, currencies are traded against each other. Usually the demand for one currency over another is governed by market forces, and money can be made from trading currencies against each other due to the change in the rate of exchange of one currency over another.

Making money in forex is a function of two factors:

a)    The extent of variation in the exchange rate between two currencies from the time the trade is initiated to the time that the trade is ended.

b)    The lot size that the trader has used in setting the trade.

Variation in Currency Prices

The exchange rate variation between two currencies is governed by market forces. If there is demand for one currency, its value will rise. If there is less demand, the value of the currency will fall. In spot forex, profits can be made from both directions. The trader can decide to buy a currency with rising demand, and make money by the upward change in value of that currency against another currency, or the trader can opt to sell a currency with a falling demand/rising supply, and make money from the reduced valuation of that currency.1c2d8_Day_Trading_Forex_Momentum_body_Picture_2

The question then arises: what are those factors that can make a currency rise or fall in valuation? This is where technical and fundamental analyses come into the play. In forex, fundamental factors play a very important role in driving currency direction. Technical plays are meant to follow the lead of the fundamentals. The fundamental drivers of currency movement are listed out in a well planned schedule of news events known as the economic news calendar. The news events are categorized into three according to market impact:

a)    Low

b)    Moderate

c)     High

Only the high impact news events create sufficient movement in the affected currencies to open up trading opportunities. Some of the high impact news are as follows:

What the high impact news events do is that they cause a sentiment shift, either telling traders to buy heavily into a currency, or to sell the affected currency and hold others instead. This leads to some of the big currency moves that are seen in the market following news releases. Once the fundamentals have kicked in, then traders can use technical plays to make appropriate trade entries and exits, in the direction of the news figures.

Lot Sizes

Position sizes in spot forex are measured in lots, with the reference benchmark being the Standard Lot, equivalent to a position size of $100,000. All other trade sizes are expressed in terms of the Standard Lot. A contract size which is one-tenth of the Standard Lot is referred to called a Mini-Lot, which 0.1 lots; a contract size of $10,000. A contract which is one-hundredths of a Standard Lot is known as a Micro-Lot ($1,000 trade size or 0.01 lots). The various multiples in contract sizes can then be derived from these reference points.

Exchange rates are usually decimalized to 4 places, so the minimum movement of a currency pair will be measured by the change in the last decimal point, known as a PIP, or Percentage Interest Point. The monetary value of a pip is determined by the lot size. A pip is worth $10 in a Standard Lot (100,000 X 0.0001) while for a Mini-Lot, a pip is worth $1. For a Micro-Lot, a pip is worth $0.1 (10 cents).

So when you put together the movement of the currency pair in pips (which is the variation in currency prices), and multiply this by the monetary value of the pip as a function of the lot size used for the currency trade, then you have the total money which is made or lost in a forex trade.

How FX Traders Make Money

So with this information which has been provided, we can now move on to describe how a typical forex trader can make money from buying or selling a currency. To properly understand this concept, please remember that currencies are listed in pairs: base currency/counter currency.

Positions are based on the base currency, so all buying or selling on currencies is done on the currency listed on the left side, which is the base currency.

a)    Making Money from the Short Trade

The short trade aims to profit from the falling value of the base currency in the currency pairing. In the case of currency trading, when taking a sell position you would borrow the currency in the pair that you were selling from your broker (this all takes place seamlessly within the trading station when the trade is executed) and if the price went down, you would then sell it back to the broker at the lower price. The difference between the price at which you borrowed it (the higher price) and the price at which you sold it back to them (the lower price) would be your profit.

For example, let’s say the analysis is that the Euro will go down relative to the USD. In this case the trade is to short the EUR/USD pair, which entails selling the Euro and buying the USD. How a short trade works is that the trader borrows Euro from their broker to purchase USD. When the value of the Euro falls and USD rises, the trader now has a higher amount of USD and with it can buy back more Euros than originally borrowed from the broker. After paying back the borrowed Euros to the broker, the rest is kept profit.

So if the EUR/USD falls from 1.3550 to 1.3500, this is a profit of 50 pips or 0.0050 points. This is now multiplied by the pip value of the lot size for the trade. So if the trader took on a 0.5 lot size position (50,000 units of base currency), this is a profit of 50,000 X 0.0050 = $250.

b)    Making Money from the Long Trade

Let us assume that the trader wants to profit from the Euro gaining on the USD. Since the account is denominated in USD, the trader simply uses his account currency to buy Euros. Let us assume a standard lot of Euros was bought at 1.3350. This means that the standard lot size of 100,000 units of base currency will get 133,500 USD. If the value of the Euro rises by 80 pips to 1.3430, then the 100,000 Euros position is now worth 134,300 USD. The profit will be 134,300 – 133,500 = $800.

Conclusion

Usually any profits made will have the spread value deducted from it. So for the long trade, the spread of $20 is deducted from $800 to give a profit of $780, and for the short trade, the profit will be $250 – $20 = $230.  This is how FX traders make money in forex.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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