Investors and traders around the world are looking to the Forex market
as a new speculation opportunity. But, how are transactions conducted
in the Forex market? Or, what are the basics of Forex Trading? Before
adventuring in the Forex market we need to make sure we understand the
basics, otherwise we will find ourselves lost where we less expected.
This is what this article is aimed to, to understand the basics of
currency trading.
What is traded in the Forex market?
The instrument traded by Forex traders and investors are currency
pairs. A currency pair is the exchange rate of one currency over
another. The most traded currency pairs are:
EUR/USD: Euro
GBP/USD: Pound
USD/CAD: Canadian dollar
USD/JPY: Yen
USD/CHF: Swiss franc
AUD/USD: Aussie
These currency pairs generate up to 85% of the overall volume generated in the Forex market.
So, for instance, if a trader goes long or buys the Euro, she or he is
simultaneously buying the EUR and selling the USD. If the same trader
goes short or sells the Aussie, she or he is simultaneously selling the
AUD and buying the USD.
The first currency of each currency pair is referred as the base
currency, while second currency is referred as the counter or quote
currency.
Each currency pair is expressed in units of the counter currency needed to get one unit of the base currency.
If the price or quote of the EUR/USD is 1.2545, it means that 1.2545 US dollars are needed to get one EUR.
Bid/Ask Spread
All currency pairs are commonly quoted with a bid and ask price. The
bid (always lower than the ask) is the price your broker is willing to
buy at, thus the trader should sell at this price. The ask is the price
your broker is willing to sell at, thus the trader should buy at this
price.
EUR/USD 1.2545/48 or 1.2545/8
The bid price is 1.2545
The ask price is 1.2548
A Pip
A pip is the minimum incremental move a currency pair can make. A pip
stands for price interest point. A move in the EUR/USD from 1.2545 to
1.2560 equals 15 pips. And a move in the USD/JPY from 112.05 to 113.10
equals 105 pips.
Margin Trading (leverage)
In contrast with other financial markets where you require the full
deposit of the amount traded, in the Forex market you require only a
margin deposit. The rest will be granted by your broker.
The leverage provided by some brokers goes up to 400:1. This means that
you require only 1/400 or .25% in balance to open a position (plus the
floating gains/losses.) Most brokers offer 100:1, where every trader
requires 1% in balance to open a position.
The standard lot size in the Forex market is $100,000 USD.
For instance, a trader wants to get long one lot in EUR/USD and he or she is using 100:1 leverage.
To open such position, he or she requires 1% in balance or $1,000 USD.
Of course it is not advisable to open a position with such limited
funds in our trading balance. If the trade goes against our trader, the
position is to be closed by the broker. This takes us to our next
important term.
Margin Call
A margin call occurs when the balance of the trading account falls
below the maintenance margin (capital required to open one position, 1%
when the leverage used is 100:1, 2% when leverage used is 50:1, and so
on.) At this moment, the broker sells off (or buys back in the case of
short positions) all your trades, leaving the trader “theoretically”
with the maintenance margin.
Most of the time margin calls occur when money management is not properly applied.
How are the mechanics of a Forex trade?
The trader, after an extensive analysis, decides there is a higher
probability of the British pound to go up. He or she decides to go long
risking 30 pips and having a target (reward) of 60 pips. If the market
goes against our trader he/she will lose 30 pips, on the other hand, if
the market goes in the intended way, he or she will gain 60 pips. The
actual quote for the pound is 1.8524/27, 4 pips spread. Our trader gets
long at 1.8530 (ask). By the time the market gets to either our target
(called take profit order) or our risk point (called stop loss level)
we will have to sell it at the bid price (the price our broker is
willing to buy our position back.) In order to make 40 pips, our take
profit level should be placed at 1.8590 (bid price.) If our target gets
hit, the market ran 64 pips (60 pips plus the 4 pip spread.) If our
stop loss level is hit, the market ran 30 pips against us.
It’s very important to understand every aspect of trading. Start first
from the very basic concepts, then move on to more complex issues such
as Forex trading systems, trading psychology, trade and risk
management, and so on. And make sure you master every single aspect
before adventuring in a live trading account.
