Principle of profiting in excgange rates

The easiest way to demonstrate the ability to profit from Forex trading as the exchange rate rises and falls is to look at some examples. Let's start by looking at how you might profit when exchange rates rise.

Let's assume that you believe that the UK Pound is going to rise against the US Dollar and that you can buy GBP/USD at 1.8730. We'll also assume that you are trading a standard InterBank lot of 100,000 so that 100,000 UK Pounds will cost 187,300 US Dollars.

To open a trade you start by borrowing 187,300 US Dollars, which you will have to repay when you close out your position.

[Note: We will not discuss the idea of borrowing to fund your Forex trading at this point but will simply note that the majority of trading is done using borrowed funds making use of leverage.]

Assuming that you are correct and that the UK Pound rises against the US Dollar and that the price moves 100 pips to a rate of 1.8830, the 100,000 UK Pounds which you purchased are now worth 188,300 US Dollars and you can close out your position and repay the original borrowing, leaving you with a profit of 1,000 US Dollars.

In real life of course it is not quite as simple as this because there will be transaction costs to pay. However, this does demonstrate the principle of profiting when exchange rate rise.

Now let's turn our attention to profiting when the exchange rate falls.

Assume this time that you believe that the UK Pound will fall against the US Dollar from its present rate of GBP/USD = 1.8730. In simple terms, you believe that the UK Pound is going to buy fewer US Dollars.

This time you will need to place a sell order for 100,000 UK Pounds at a cost of 187,300 US Dollars. In other words, you borrow 100,000 UK Pounds and sell them for 187,300 US Dollars.

Assuming once more that you are right and that the rate falls by 100 pips to GBP/USD = 1.8630, you can now close your position by buying back and repaying the 100,000 UK Pounds which you originally sold. In this case this will now cost you 186,300 US Dollars and you will once more make a profit of 1,000 US Dollars.

Again we have ignored any transaction costs to simply demonstrate the principle of profiting from a fall in exchange rates.