Picture: ISTOCK
Picture: ISTOCK

With the rise of Instagram traders and overnight billionaires, it's no wonder there's a lot of confusion out there about what forex trading is and how traders make money.

Forex traders make profit by taking advantage of movement between two currencies. It's important to note that a movement between the currencies is in relation to each other.

Forex trading is a lot more complex than trading equities. A lot of seasoned forex traders - who still make mistakes - recommend starting with trading shares to get a better feel for market dynamics.

And forex scams, like the 2005 Leaderguard one in which investors, including many pensioners, lost R350-million, prey on those who are in the dark about the inherent risks in the forex products they were offered.

If you want to trade forex you need to do your homework, and you shouldn't trade with money you can't afford to lose. Also don't expect to be, or accept being, spoon-fed by your service provider.

The principle of forex trading is as follows: say the rand is trading at R13 to the dollar. At that rate, you decide to purchase $1 000. You'll pay R13 000 for that $1 000.

Should the rand fall to R13.50, selling your $1 000 at that rate will yield a R13 500 return, resulting in a R500 profit.

To complicate matters there's the added elements of gearing and leverage.

Gearing is the process of borrowing money to trade, while leverage is the measure of the borrowed funds in relation to available capital. Leverage allows traders to trade larger volumes than they would otherwise be able to trade. Different trading platforms offer different types of leverage or gearing options.

Using the example above, suppose you have R10 000 in your forex account. If your broker allows you a leverage of up to 20:1 - this means that you can trade up to R20 for every rand you opt to trade.

To do this, you'll have to open a margin account where you can borrow the currency you wish to leverage. If you want to trade R10 000 at 20:1, you'd have to borrow R200 000 (20 times R10 000) to cover your leverage position as collateral.

Using the rand example above, you can use your R200 000 to buy the dollar at R13 a dollar. If the rand falls to R13.50, you'll get R207 692.31. That's a profit of R7 692.31 - significantly more than what you put down.

But this is simply an illustration. In real life the trading process includes bid and offer prices. The difference between these is known as the spread.

As much as leveraging amplifies your profits, you can also lose money if the currency you're trading moves in the opposite direction to what you expected. An adverse movement means you may lose money you've borrowed, and you will become liable for covering that shortfall.

To get a full understanding of how it works in real life, it's important to try your hand at forex trading using a free demo account. If your service provider doesn't offer one, shop around.

Forex markets trade around the clock, so managing your position and minimising risk is crucial. You don't want to wake up to a bloodbath. Put the stop-loss function to good use, even if you've opened a position.

A stop-loss function will allow you to limit your losses.

When it reaches a certain level, the stop-loss kicks in and will close your position or trigger a sale of the security. Some platforms allow you to select whether you want to sell at that level or just exit your position without further action.

A positive outcome is not a given, so you should be wary of trading platforms that offer guaranteed returns. It's impossible to consistently guarantee a return. If it was, every single trader would be wealthy.

To minimise your losses as a beginner trader, don't allow the possibility of high returns to override your ability to shoulder a potential loss. Just because you're offered a large amount of money to take on a big leveraged position doesn't mean you must take it. Start small.

Be careful not to turn your trading journey into a gambling spree. If you lose, don't throw even more money in in the hope of making up for the loss, especially if you're in panic mode. It's unlikely you'll be able to do so. It may be best to step back, reassess your strategy, study your charts and then decide on your next move.

Tsamela is the founder of piggiebanker.com. Follow her @PiggieBanker.

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