Foreign exchange, or forex as it is commonly known among traders, is the market where you buy and sell currencies. You use whatever money you currently have (say, Deutsch Marks) to purchase another currency (say, the Japanese Yen). In reality you are exchanging one form of currency for another.
Travelers exchange currencies all the time, but not in large amounts of money and not very frequently. Nor do most travelers trade in currencies, much less multiple currencies
A foreign exchange trader may exchange currencies throughout the day. They do this because the exchange rates of currencies are constantly changing. Currency valuations are set by market expectations based on breaking news or rumors about impending events that may threaten or strengthen currencies.
For example, investors may sell off their currencies for a country if they feel that nation is threatened by war, inflation, a recession, or government policies. All of these situations may change over time and investors might put their money back into a currency.
Not every investor is looking to “buy low and sell high” in foreign exchange. Sometimes investors move money from currency to currency before making large asset purchases. They may be required to do this by law or it may be that they anticipate a more favorable environment for a different currency at the time the deal closes.
Forex traders know that they have to be at the top of their game. They monitor world-wide news and financial trends carefully. Even so, most people don’t make much money in foreign exchange trading. Why is that? Several reasons.
First, you are only going to make a relatively small margin on any trade. You have to deduct fees for the brokerages you use and you may be paying for special services that assist you in watching the markets. But the exchange rates can vary by only a few percentage points, or even less than a percentage point.
Hence, when you exchange one currency for another it is best to do so with large sums of cash. And most people who want to make money through forex trading simply don’t have enough money to “bootstrap” their investments into large enough pools of cash to make any real profits.
Second, you have to pay taxes on your earnings. You may be able to deduct your losses but at the end of the day any tax obligations you owe your government reduce your realized profit and may shrink your pool of available cash below where you started.
Third, timing is incredibly important and most people do not time the markets well enough to succeed. No one is always right about when to make a trade but some experienced traders buck the trends and make more successful trades than average investors. So until you develop the resources, experience, and intuition to make more successful trades than bad trades the chances are very good that you won’t make much money in forex trading.
Finally, unexpected events may cause a currency to lose value much faster than even the best, most experienced traders anticipated. If you are caught with all your money invested in one currency you are extremely vulnerable to disaster-driven devaluations. A volcano could explode, an earthquake could level a city, a tsunami could strike a major tourist area, a powerful storm could destroy coastal infrastructure — these unexpected and largely unpredictable events may destroy many months’ worth of profits in a matter of hours or days.
Good forex traders diversify their investments. They may “wait out” a downtrend in one currency just to be sure they have a reserve fund to work with in the future. Downtrends in currency valuations, like stock and bond valuations, happen all the time. For the reasons given above it is not always a good idea to trade out of a currency just because it loses a little bit of value. If you’re not going to make a profit AND if you don’t have a good, stable currency to trade into, it is better to leave your money where it is until a good opportunity comes along.
Trading in any exchange market calls for discipline and self-restraint just as it does for knowledge and timing. Your intuition is not always your best friend. It may be right about an impending change in valuation but you have to take other factors into consideration before making that critical trade.