What Are You Really Trading?

FX traders hope to profit from changes in exchange rates between currency pairs. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader’s account.

The FX market exists to help with the exchange of one currency into another, a facility used by multinational corporations that need to continually trade currencies (i.e., for payroll, payment for goods and services from foreign vendors, and mergers and acquisitions). Financial institutions use the forex markets to hedge positions and take directional bets on currency pairs based on fundamental research and technical analysis. Individual traders may also trade currencies to speculate on exchange rate moves.

Since currencies always trade in pairs, when a trader makes a trade, that trader is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, they would have exchanged euros for dollars and would now be short euros and long dollars.

To better understand this dynamic, an individual who purchases a computer from an electronics store for $1,000 is exchanging dollars for a computer. That individual is short $1,000 and long one computer. The store would be long $1,000, but now short one computer in its inventory. The same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.

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