Forex, short for foreign exchange, is a financial derivative. The actual underlying asset is currencies.
Sounds profound? To put it simple, foreign exchange is the act of changing one type of currency into another type of currency. Ahhh yes! Now you get it. Many of us have done this when we are travelling to other countries. While you exchange the currencies to spend in another country during your holiday, when it comes to forex trading, we buy/sell currencies (in pairs) for the purpose of profiting from the trades.
Forex is by far the largest market in the world.
- It never sleeps. It is a true 24-hour market from Sunday 5 PM ET to Friday 5 PM ET. forex trading begins in Sydney, and moves around the globe as the business day begins, first to Tokyo, London, and New York.
- No one can corner the market. It is different from other markets whereby big fish control everything. Being such a huge market and with so many participants, there definitely no single entity can control the market price for an extended period of time.
- Low Barriers to Entry. Yes, you don’t need a ton of money to get started to trade forex.
- High liquidity. With a click of a mouse you can instantaneously buy and sell. As there will usually be someone in the market willing to take the other side of your trade and thus you are never stuck in a trade.
- Lower Transaction Costs. The retail transaction cost (the bid/ask spread) is typically less than 0.1% under normal market conditions. At larger dealers, the spread could be as low as 0.07%.
- Leverage – Trading on Margin. In Forex trading, a small deposit can control a much larger total contract value. This can allow you to take advantage of even the smallest moves in the market.
Well, there are still some terminologies to understand before you get started.
Currency pair – The quotation and pricing structure of the currencies traded in the forex market: the value of a currency is determined by its comparison to another currency. The first currency of a currency pair is called the “base currency”, and the second currency is called the “quote currency”. The currency pair shows how much of the quote currency is needed to purchase one unit of the base currency.
Exchange Rate – The value of one currency expressed in terms of another. For example, if EUR/USD is 1.3200, 1 Euro is worth US$1.3200.
Cross Rate – The currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. This phrase is also sometimes used to refer to currency quotes which do not involve the U.S. dollar, regardless of which country the quote is provided in.
Spread – The difference between the bid and the ask price. When you trade currencies, you watch the numbers in your currency pair. If the currency you hold has a higher number than that of the currency you are about to trade for, you will make a profit. If the reverse is the case, you will take a loss. Naturally, making a profit is in your best interests.
Pip – The smallest price change that a given exchange rate can make. For example, the smallest move the USD/CAD currency pair can make is $0.0001, or one basis point.
You must have noticed, there are always three letters in the symbols to represent all currencies. The first two letters denote the name of the country and the last one stands for the name of that country’s currency. Let’s take the USD for example. The US stands for United States and the D stands for Dollar. In forex trading, we often hear people mention the term of ‘major currency’. As the name reveals, it refers to the currencies on which the majority of the traders focus. The most widely traded currencies are listed below:
Don’t get confused with major currencies and the major currency pairs. The Major Pairs are any currency pair with USD in them, either as base currency or cross currency.For instance, the EURUSD would be treated as a Major Pair.
Currency pairs without the USD in them are referred to as Cross Pairs. The EURJPY would be an example of a Cross Pair.
Also, it would be considered as a Euro Cross if there is no USD in a EUR pair. So the EURJPY pair would be an example of Euro Cross. In the Euro Cross group, there are members like EURGBP, EURCHF, EURNZD, EURCAD and EURAUD. Similarly, there are currency groups like JPY crosses, GBP crosses, AUD crosses, NZD crosses and the CHF crosses.
The Long & Short of It.
Aspiring traders will often be familiar with the concept of buying to initiate a trade. Afer all, since young, many of us have been taught the basic concept of ‘buying low and selling high’.In financial markets, jargon often plays a key role. Jargon helps show familiarity and comfort with a particular subject matter, and nowhere is this jargon more apparent than when discussing the ‘position,’ of a trade.The trade is said to be going ‘long’ when the trader is buying with the belief of closeing the trade at a higher price later on.This may seem easy, the next may be a bit more unconventional to beginners.The idea of selling something that you don’t actually own may be a confusing idea, but in their ever-evolving pragmatism traders created a mannerism for doing so.When the trader is going ‘short’, he/she is selling with the objective of buying back at a lower rate. The difference between the initial selling price, and the price at whice the trade was closed, and less any fees, commissions,is the trader’s profit.It’s important to mind the interesting distinction between currencies and other markets. Because currencies are quoted in a pair, each trade offers the traderlong and short exposure in varying currencies.For example, a trader going short EUR/JPY would be selling Euro and going long Japanese Yen. If, however, the trader went long the currency pair – they would be buying Euro and selling Japanese Yen.
Trading Forex is all around the basic concepts of buying and selling.
Let’s look at buying first.Imagine, something you bought went up in value. The reason why you sold it was because you can make a profit, which is the difference between the money you paid in priginally and the money you received when you sold it off.
Well, it works the same way here.
Let’s say you want to buy EURUSD pair.If the AUD goes up relative to USD, you will make a profit if you sell it.If the AUDUSD was bought at 1.0605 and it moved up to 1.0615 at the time that the trade was closed, there was a profit of 10pips. If the pair moved down to 1.0600 at the time that the trade was closed, the loss would have been 5 pips. This stands true for all currency pairs.You will make a profit as long as the price of the currency you are buying goes up from the time you bought it.
Here is another example using the AUD.In this case we still want to buy the AUD but let’s do this with the EURAUD pair. In this scenario, we would sell the pair. We would be selling the EUR and buying the AUD at the same time.If the price of AUD goes up relative to the EUR, we would be making a profit as we bought the AUD.
In this example if we sold the EURAUD pair at 1.2300 and the price moved down to 1.2250 when we closed the position, we would have made a profit of 50 pips. If the pair moved up and we closed the position at 1.2350, we would have lost 50 pips.
Keep in mind that we are always buying or selling the currency on the left side of the pair,which is called the base currency.If we are buying the base currency, we are selling the one on the right side, which is called the cross currency.
Likewise, if we are selling the base currency, we are buying the cross currency.
How can a trader make a profit by selling a currency pair? This is a bit trickier.It is basically selling something that you borrowed rather than selling something that you own.
In the case of currency trading, when taking a sell position you would borrow the currency in the pair that you were selling from your broker (this all takes place seamlessly within the trading station when the trade is executed) and if the price went down, you would then sell it back to the broker at the lower price. The difference between the price at which you borrowed it (the higher price) and the price at which you sold it back to them (the lower price) would be your profit.
For example, let’s say you believe that the USD will drop relative to the JPY. You would want to sell the USDJPY pair,
meaning, selling the USD while buying the JPY at the same time.You would be borrowing the USD from your broker when the trade is executed.If the trade moved in your favor, the JPY would go up in value and the USD would go down. When the trade is closed, your profit from the JPY increasing in value would be used to pay back the broker for the borrowed USD at the current lower price. The remainder would be your profit on this trade.
For example, let’s say the trader shorted the USDJPY pair at 76.40. If the pair moved down and the trader closed/exited the position at 75.80, the profit on the trade would be 60 pips.
However, on the other hand, if the USDJPY pair was shorted at 76.40 and instead of moving down but rahter moved up to 76.60 when the trade was closed, you would suffer a loss of 20 pips on this trade.
In a nutshell, this is how you can make a profit from selling something that you do not own.
Keep this in mind, if you buy a currency pair and it moves up, that trade would show a profit. If you sell a currency pair and it moves down, that trade would show a profit.
What is Leverage
Leverage is a financial tool. It allows you to increase your market exposure. For instance, a trader buys 10,000 units of the USD/JPY, with $1,000 dollars of equity in his/her account.
The USD/JPY trade is equivalent to controlling $10,000. The reason being the trade is 10 times larger than the equity in the trader’s account, the account is therefore leveraged 10 times or 10:1.
So, if a trader buys 20,000 units of the USD/JPY, which is equivalent to $20,000, their account would have been leveraged 20:1. Leverage allows a trader to control larger trade sizes. Traders will use this tool to magnify their returns. At the same time, the losses are also magnified when leverage is used. Therefore, it is crutial to use leverage with some control. Over here, we believe that you will have a greater change of long-term success with a conservative amount of leverage, or even no leverage is used.