Firstly lets talk about what investing in foreign exchange means. It does not mean buying foreign currency and keeping it up until it fairs well in value. Converting the money you have and holding it till it appreciates in value can take you only so far, usually you may earn about a few dollars over a period of an year by doing that. Then what does it mean? It means actively trading currency in a foreign currency market place or and exchange.
Before going into details, lets see how a FX market really works. In FX markets there is no concept of buying a currency, there is always an exchange of currencies, one being bought and the other being sold. Lets take this to a level that we are all comfortable with; You'd usually 'buy dollars', but what we actually do is exchange the local currency we have into USD at the current market rate. Lets assume the dollar is at 105 local currency units now, we'll spend 210 / = and buy 2US $ and will keep the dollars with us. If the dollar rises to 110 / =, our investment has also appreciated. To make use of the appreciation, we have to re-sell the dollar at 110 / = and we would have made a profit of 10 / = on the transaction. Now look at this from a purely external point of view. Intially the investor gives out some currency to buy another sort. Then when the rate rises, he sells what he originally bought and buys back the depreciated currency. The difference in the rate he bought at and sold at, is his profit.
In a forex market, you'll trade something thats called a currency pair. This will look something like EUR / USD. If you buy this, you will actually exchange the USD that you have with Euros. When you've bought a currency pair, its called opening a position. But just because the Euro went up, you cant benefit from it. You have to convert it back to the original USD to compare the profit. So how would you do this? You have to exchange the EUR you have to USD, ie you close the position that you opened. Lets take an example: In current market the value of the EUR / USD is about 1.57 ie each Euro is worth 1.57 times the USD. Lets say you have 157 USD, you exchange this for a 100 EURs (ie you open a position by buying the EUR / USD pair). Tomorrow, the EUR / USD rate might turn out to be 1.5730, the EUR has gained slightly. Let say that you close the position now, you have 100 EURs which converts to 157.30 USD, you've gained 30 cents on your investment. See? pretty easy.
You may ask how this is any different to buying foreign currency and holding it till it goes up. The reason is because with a bank, you can only exchange the LKR with the majors (USD, EUR, JPY, GBP). Lets say the Dollar started appreciating against the GBP; you really cant do anything about it. (eg: USD is say 105 / = and say GBP is somewhere around 200 / =, you have LKR with you and all of a sudden USD starts going down all the way to 100 / =. The effective rate of GBP / USD at the beginning was 1.9047 at the end of the event, the rate is 2.00. If you could trade the GBP / USD pair, you could have made a profit on this. But you cant cos you have only LKR. Well yes, you could convert the money to USD and then to GBP and wait until it goes up and … bit of a process yes?) In a forex dealing place, the conversion will automatically done for you; You can deposit your money in USD and actually trade a pair like EUR / JPY.
Well what you've just read through is all a lie. But its an important lie to get introduced into dealing in forex markets. To be fair, the above sums up the principle of a forex dealing place; It will help you to understand how the profit and loss taking really happens. But thats not how it operates.
Like everything else, forex rates are also based on the demand for the currency. And also like in most of the international markets, the currency rates are determined by large traders who do transactions worth several millions of dollars per trade. When you buy USD from a local bank, they sell you the dollars they've bought from the international market. This is exactly what a forex dealing exchange does. (ie This is what a forex dealing exchange for normal people like you and me does. I have no idea how exactly the bigger deals work out); they channel all the orders from their user base into dealing places for large banks.
We know that with an exchange place we will be trading currency pairs. The rate of the currency pair would typically be expressed in five numbers.
GBP / USD = 1.9825
USD / JPY = 106.38
The smallest change possible for each pair is known as a pip. (ie for GBP / USD this is 0.0001, for USD / JPY this is 0.01)
In most exchanges, each lot of the traded currency is in lots of 10,000. Thus, if you buy 1 lot of GBP / USD at 1.9825, you are actually buying 10,000 GBP. The amount of USD you spent for this is 10,000 * 1.9825 = 19,825 USD. Let's say you hold the currency pair till the rate goes up to 1.9830. You will close out the position by selling the GBP and buying the USD. Thus you will sell out 10,000 GBP and buy USD. This would yield 19,830 USD; the rate of the currency increased by 5 pips and your profit increased by 5 $. If each lot was 100,000 units of the currency, then for the same 5 pip increase, the profit would be 50 $. For any currency pair that looks like X / USD this is the case.
Let's look at the USD / JPY pair now. Pair is at 106.38 and you buy it, ie you buy 10,000 USD by spending Japanese Yen. Now that's a problem right? Cos you deposited the money in USD but definitely you don't have any JPY. Not a problem. The exchange knows that what you'll do is opening up a position and later closing it. Thus you'll buy some USD spending the JPY you don't have and buy back the JPY later. So the exchange will settle the net cash amount for you without bothering to look whether you have JPY or not. So lets say you buy the USD / JPY pair for 106.38, you buy 10,000 USD spending JPY. If you had JPY, what would be the worth of it? You'd spend 10,000 * 106.38 JPY to open the position. Now let's say the currency pair rises to 106.48 and you close the position. What you'd technically do is to sell out the 10,000 USD and buy back the JPY. The amount of JPY that you'd receive would be 10,000 * 106.48. Thus your JPY worth has gone up by 1,000. If you convert this to USD, it would be a net gain worth 1,000 / 106.48 = $ 9.39. What the exchange does is to pay out this 9.39 $ to you. There is no need to convert your dollars to anything or whatever. Every one is happy.
Obviously, its not easy to calculate the gains or losses on a non USD denominated currency pair (like USD / JPY or AUD / EUR). Thus the brokers (the correct name for 'exchanges') publish lists of 'pip costs'. It tells you how much of a gain or loss you'd make if the pair moved by one pip.
Now in this example we saw that the traded value of each pair is worth several thousands of dollars. Obviously a normal individual would not have access to that amount of money. This is where leverage comes in. The brokers let you play with money that is much more than what you have, this is known as leverage. Typically a forex broker would offer leverages from 50: 1 to 200: 1. What does this mean? This means that to do a trade worth 10,000 $, with a 50: 1 leverage, you need only 200 $. With a 200: 1 leverage, you can do the same trade for 50 $.
This may look very lucrative, but it means that you are also at a large risk. Lets say you put 50 $ for a 200: 1 leveraged trade. The maximum loss you could make is 50 $ (as the broker will not allow you to make a loss for more than what you have. If that becomes the case, a 'margin call' will fire and most likely your position will be automatically closed . This is done as a safety mechanism for the broker to not to have clients running large losses and not covering them.) To lose 50 $, your currency pair needs to lose 50 pips. In the currency markets 50 pip move can happen in a matter of few hours. Now lets say you had a leverage of 50: 1, then you would need 200 $ to do the trade and even with a 50 pip loss, you'd still have 75% of your investments left. If you are dealing with large leverages, its necessary to have a large percentage of your deposit not allocated in a trade to make sure you don't lose out on price spikes. (We'll talk about this later on another topic where I plan to talk on how to play with currencies).