Currency trading happens for two reasons. The first, and the simplest reason is, a Mr. X from the United States wants to go for a holiday in Australia. But he fears that the US dollar might not be as easily accepted in Australia, because it has its own currency, the Australian Dollar. So to be able to buy gifts for the rest of his family, he decides that he'd better convert the USD to ASD to avoid any problems. Simple enough.
But another Mr. Y decides to buy Australian Dollar, not because he's looking for a sojourn on the Gold Coast, but because they are available at rate which he believes will increase. Confused? Let me explain with the help of an example. Suppose today Mr Y can buy 3 ASD in exchange for 1 USD, and - just for a moment, assume that - he can sell them tomorrow for 2 USD, he's going to make a tidy little profit of $1 on what is widely known as the Foreign Exchange (Forex) Market. But why will the price of 3 ASD jump from 1 USD to 2 USD? Because of the fluctuations in the demand and supply of various currencies in the Forex market.
Foreign Currency Trading
Firstly, let me explain why the price of the ASD is going up. The Forex market works on the old demand-supply model. This means that if the supply of one currency is less (in this case the ASD) and the demand for it is high, then the currency is going to command a higher price in the Forex trading market. Now Mr. Y must have done some very detailed research into the expected demand for the ASD before he came to the conclusion that since the demand will increase tomorrow, he can buy it today for a lower price and make a profit tomorrow. Roughly speaking, the Forex market too works like the stock market. Say you are holding the shares of Shell on the stock exchange, and if Shell finds some serious quantity oil, then the price of the shares will shoot up and the current holders of shares of Shell will make a good profit. Similarly, if the price of a currency is expected to rise in the near future, one could buy the currency and then sell it at a higher price.
Now let us look at some basic terms used in currency trading and their meanings.
Bid/Ask: In the Forex market, there are two prices. One is called the 'bid' price and the other is called the 'ask' price. For example, as of writing this article, the price of a EUR/USD (one Euro to US dollars) was 1.4161/65. Out of these two the 'bid' price is the lower one (1.4161) and is the dollar price that the person who wants to buy the Euro is quoting i.e. he is offering to buy 1 Euro in exchange for $1.4161. The second number (1.4165) is the price that the holder of the Euro is 'asking' i.e. the person who is holding the Euro is demanding 1.4165 dollars in exchange for the 1 Euro.
Pip: A pip (price interest point) is the incremental move which one currency makes over the other. In the previous example, we took the EUR/USD to be 1.4161, if the bidder ups his bid to 1.4165 to match the asker's rate, then it is said that there was a move of 4 pips. If the currency prices are more disparate - like in the case of GBP/INR, (English Pound to Indian Rupee) if it moves up from 78.86 to 78.92 it is still a jump of 6 pips. Pips are calculated on the last two digits on the right of the decimal point.
Why Does the Demand for a Currency Increase/Decrease?
Since the price of the currency is largely dependent on the demand for it, we need to understand what causes the shifts in the demand while learning currency trading. By knowing what are the causes of the changes in demand, we can taken an informed decision on whether or not to buy currency or sell the currency we have in hand. The number of factors which influence the demand are GDP, inflation and interest rates, trade agreements between the countries whose currency is being traded, budget plans, budget deficits, how the national stock market is doing and overall economic and political soundness of the country. For example, suppose the capital market of an emerging market like Brazil is doing rather well. And the nation is earning a substantial GDP and there are no political troubles whatsoever. In such a case, Brazil will be viewed as a potential target for multinationals to invest in. The Brazilian stock market will also come under the radar of foreign institutional investors. Hence, to invest in Brazil and Brazilian companies, one will need Brazilian currency. So the Brazilian currency will be in great demand. This drives the price of the Brazilian Real higher.
Currency market is a highly speculative market and one needs to do a very detailed research before buying currency, in order to make a profit.
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