Exchange Rates

Forex traders make their livings predicting changes in currency exchange rates. Using both fundamental and technical analysis it is possible to anticipate rising or falling exchange rates. The fundamentals in currency trading are monetary policy, politics, social unrest, and economics of the nations whose currencies on trades. Currencies always trade one versus the other. The Forex system was set up to support global commerce. If an American company, such as Boeing, wishes to sell its product, airplanes, to a Japanese airline it will want to receive payment in US dollars. The Japanese airline will need to convert Yen to dollars in order to make payments. Because the relative value exchange rates of the Yen and US dollar vary over time the Japanese company will often hedge its currency risk by trading currency ahead of when it needs to make payment, buying or selling futures in the US dollar with Yen, or buying calls on the US dollar with Yen.

In the example given above the Japanese company may well choose to buy calls on the dollar with Yen. It will protect itself against an upward movement of the greenback versus the Yen. If the dollar does rise in value the company will execute its call option and buy dollars at the price existing that the time of the options contract, the strike price. It will effectively lock in the most that it will have to pay for delivery of an airplane. Of course if the Yen rises against the dollar the company will not execute the contract. Rather it will simply convert its stronger Yen into weaker dollars and receive its shipment of Boeing jets for less than the contract price, in Yen, even though the price in dollars will be the same.

This is hedging of exchange rates, also known as hedging of currency risk. It is the basic reason for options trading in Forex markets. However, speculators in Forex profit for changes in exchange rates simply by buying or selling currencies, buying or selling futures, or buying or selling options on currencies. One need not be doing business internationally in order to engage in currency trading for a profit.

Traders in Forex commonly use the leverage available in trading account to enhance their profits from speculating on exchange rates. However, where there is the potential for profit there is the potential for loss. Smart traders always use limit orders in order to contain their risk in case of a large, unanticipated, and adverse market move when trading currencies. It is possible to trade with hundredfold leverage in Forex. For the well prepared and disciplined trader this can result in substantial profits and for the undisciplined and unprepared trader in can lead to a margin call as losses exceed the size of the trading account. At that time the trader receives a margin call. He either replenishes the account or the broker sells account assets to cover losses and bills the trader for the remainder. Such is the world of trading exchange rates in foreign currencies.