How Forex Trading Works
Trading forex is exchanging 1 currency to another currency to get benefit from changing
price rates of a currency, compared to the other one. For example :
A trader makes a profit by Buying Great Britain Pounds (GBP)
Trader's Action
Great Britain Pounds (GBP)
US Dollars (USD)
A trader purchased 10,000 pounds in the beginning of February 2007 when the GBP/USD rate was 1.9800.
+10,000
-19,800 *
The following day, the trader exchanged his 10,000 pounds back into US dollar at the market rate of 2.0000.
-10,000
+20,000 **
In this example, the trader earned a gross profit of $200.
0
+200
* $10,000 x 1.9800 = US $19,800
(The trader bought GBP of 10000 by selling USD of $19,800)
** $10,000 x 2.0000 = US $20,000
(The trader sold back GBP of 10000 by buying again USD of $20,000)
Trader's Action
Meaning
Buy EUR/USD
Buy EUR by selling USD
Sell EUR/USD
Selling EUR to buy USD
Why currencies are always traded in pairs ?
While forex is about exchanging a currency to another currency simultaneously (buying 1 currency and selling the other at
the same instance) that is why currencies are always quoted in pairs, for example GBP/USD, EUR/USD, etc.
You will gain from differences of traded currency price rates
A currency pair depicts a quotation of two different currencies. The first currency in the pair is the base currency. The
second currency in the pair is labelled quote currency or counter currency. Such a quotation depicts how many
units of the counter currency are needed to buy one unit of the base currency.
Current forex quote displays GPB/USD = 1.8500, this means to BUY 1 pound GBP needs 1.85 USD.
For example the quotation EUR/USD 1.2500, while Euro is the base currency and USD is the quote or
counter currency.
It means that one euro is exchanged for 1.25 US dollar. If the quote moves from
EUR/USD 1.2500 to EUR/USD 1.2510, the euro is getting stronger and the dollar weaker. On the other hand if the EUR/USD
quote moves from 1.2500 to 1.2490 the euro is getting weaker while the dollar is getting stronger.
Cross Rate is an exchange between two currencies that does not include official currency of a particular country which the
exchange is taking place.
For example a transaction of GBP/JPY is taking place in the US. Then GBP/JPY is considered as
cross rate for United States.
Try to understand this :
Currency Pair
Price Chart is moving
EUR (base)
USD (quote)
EUR/USD
Upward
Stronger
Weaker
EUR/USD
Downward
Weaker
Stronger
You can also say that if we Buy EUR/USD, it is the same as we are buying EUR (base currency) and at the same
time we are selling USD (quote currency).
Pair EUR/USD:
If you predict that EUR will be stronger than USD, then you can Buy EUR/USD.
If you predict that USD will be stronger than EUR, then you can Sell EUR/USD.
Pair USD/JPY:
If you predict that USD will be stronger than JPY, then you can Buy USD/JPY.
If you predict that JPY will be stronger than USD, then you can Sell USD/JPY.
Forex Quote, Bid, Ask (Offer), and Spread
The quotation of a currency pair usually consists of two prices.
Bid (usually lower than Ask) is the price at which
a market maker or a brokerage is willing to buy the base currency in exchange for the quote currency (or we could say, bid is the trader's selling price).
Ask or Offer (usually higher than Bid) is the price at which
a brokerage is willing to sell the base currency in exchange for the quote currency (or we could say, offer or ask is the trader's buying price).
So please note that Ask or Offer is always higher than Bid
Conclusion:
Bid is the price at which trader will get while he sells (trader’s selling price)
Ask / Offer is the price at which trader will get while he buys (trader’s buying price)
Bid is usually lower than Ask.
Spread is the difference of Bid and Ask / Offer. The smaller the spread the more profitable to trader
If the quotation of EUR/USD is 1.2293/1.2296, then the spread is EUR 0.0003 (3 points or pips)
Forex quote example :
Please note :
If you open Buy (going Long), you buy with Ask price, and will have to use
Bid price while selling it back (liqudating/closing, stop loss, and taking profit also use Bid)
If you open Sell (going Short), you sell with Bid price, and will have to use
Ask price while buying it back (liqudating/closing, stop loss, and taking profit also use Ask)
While we are Buying (going Long) with Ask, we have to pay attention to Bid at forex quote
table / list. Bid must be HIGHER than Ask price we initially bought (the price at which we opened the position) in order to
earn Profit
While we are Selling (going Short) with Bid, we have to pay attention to Ask at forex quote
table / list. Ask must be LOWER than Bid price we initially sold (the price at which we opened the position) in order to
earn Profit
Example :
A trader opens BUY (Long) GBP/USD at 1.9902 (Ask), in this case, if current Bid price is
still at 1.9899, means the trader’s position is at floating loss of 3 pips. To earn profit you have to wait until current
bid price goes above 1.9902. You may notice that each time you open a new position, there are initial
negative pips at the SAME amount as the spread of
corresponding pair you use. This initial negative pips are caused by spread charges
High : The record of highest price reached at the time range from opening to the closing of a specific timeframe.
(example : for chart with 5 minutes timeframe, High price means the highest price of the corresponding 5 minutes chart)
Low : The record of lowest price reached at the time range from opening to the closing of a specific timeframe.
(example : for chart with daily timeframe, Low price means the lowest price of the corresponding daily chart)
Open : Opening / initial price of a specific timeframe. (example : for chart with 5 minutes timeframe, the first /
opening price of the current time frame is 2.0000. This means Open Price for current timeframe is 2.0000)
Close : Closing / ending price of a specific timeframe. (example : for chart with 5 minutes timeframe, the last /
ending price of the current time frame is 2.0050. This means Close Price for current timeframe is 2.0050
What is Long / Short ? LONG or open BUY means buying a currency with the expectation to sell it at higher price.
Traders earn profit if the price they bought is lower than the price they sold. (profit while the chart is moving upward / profit from a increasing market).
Example : A trader opened BUY EUR/USD at 1.1500, he sold EUR/USD at 1.1525, in this case he will earn 25 points profit.
Please remember, to get the profit, a trader has to sell back (liquidate or close or settle) what he has bought.
Upward movement of currency pair indicates Base currency of the pair is getting stronger than Quote currency. Example :
EUR/USD chart increase indicates that Euro becomes stronger than USD. EUR/USD decrease indicates that Euro becomes weaker
than USD
The price used to OPEN BUY / LONG is Buying Price (ASK) and the price used to close /
liquidate / sell back is Selling Price (BID).
LONG position is usually known as BUY for short
SHORT or open SELL means selling currency to anticipate decreasing value, then buy it back
at lower price
Traders earn profit if the price they sold is higher than the price they bought. (profit while the chart is moving downward / profit from a decreasing market).
Example : A trader opened SELL USD/JPY at 110.50, he bought USD/JPY at 110.00, in this case he will earn 50 points profit.
Downward movement of currency pair indicates Base currency of the pair is getting weaker than Quote currency. Example : USD/JPY chart decrease indicates that USD becomes weaker than JPY. USD/JPY increase indicates that USD becomes stronger than USD
The price used to OPEN SELL / SHORT is Selling Price (BID) and the price used to close /
liquidate / buy back is Buying Price (ASK)
SHORT position is usually known as SELL for short
Position
Initial Action
Closing Action
Price Moving Up
Price Moving Down
Long
Buy
Sell
Profit
Loss
Short
Sell
Buy
Loss
Profit
What are point (pip) and Contract Size (Lot) ?
A point (pip) is the smallest number in a quotation of a currency.
For example if the quotation of EUR/USD is 1.2025, a pip is represented by 0.0001. However, for a different currency such
as USD/JPY 116.25, a pip will be 0.01.
In order to calculate the pip value or “how much you will earn for one pip”, you have to know some additional information
such as: contract size (Lot) and the pair used
Example :
EUR/USD contract size : 100,000 units (1 standard lot), 1 pip loss or profit equals to $10. While a trader closes 10 points of profit, total profit he earns is $10 x 10 = $100.
The same calculation also applies for loss.
Contract Size (or Lot) is the smallest trading amount / quantity for exchanging currencies.
The common size are mini and standard lot. The standard lot is equal to 100,000 units while mini is equal to 10,000 units.
For example : A forex broker offers you mini lot account, you can trade in incremental of 10,000 units. for example :
20,000 units, 110,000 units, and so on. A forex broker which only supports standard lot will allow you to trade with
incremental of 100,000 units. For example : 300,000 units, 1,000,000 units, and so on
Contract Size value (in Lot Volume):
1 Lot : 100.000 unit (or 1 Standard Lot)
0.1 Lot : 10.000 unit (or 1 Mini Lot)
0.01 Lot : 1000 unit (or 1 Micro Lot)
Margin and Leverage Ratio Leverage is borrowed capital to increase potential return.
With leverage function, a trader does not have to deposit $10,000 in order to trade $10,000.
He can give $100 (1% of contract size) as good faith deposit to trade $10,000 while trading at brokerage which offers
Leverage 1:100. Leverage is commonly available in ratio, example : 1:50, 1:100, 1:250, or 1:500.
Imagine, if another trader trades forex without leverage. He must have at least $10,000 to trade $10,000 lot (1:1). At
above scenarios, both traders have the SAME potential profit but the first trader’s margin requirement is a lot smaller
than the second.
Conclusion : Leverage makes a trader with smaller equity to have the SAME potential profit as trader with much bigger
equity
Margin is good faith deposit required to open an order.
Margin is temporarily held by brokerage until the order is closed / settled. Keep in mind that margin is held by your
broker until the order is closed. Right after the position is liquidated, the margin will be credited back to your balance.
Margin is quantified in percentage and affected by Leverage offered by forex broker. Example : Leverage 1:100 = 1% Margin
Requirement, Leverage 1:50 = 2% Margin Requirement, and so on.
Lets say, you have $1000 cash deposited to your broker with Leverage 1:100. The maximum contract size (lot) you can trade
is almost 1 Lot of $100.000 (almost 100 times the balance). It can also be said that to trade 1 lot of $100.000, the broker
needs 1% x 100,000 = $1000 margin
Another example :
You have $500 cash deposit and your broker offers Leverage 1:100. In this case, if you open 1 mini lot
(10.000 unit), the margin held is 1% of the contract sizenya (10.000) = (1% x 10.000) = $100 Margin.
Your $100 margin will be locked temporarily by your broker, and the rest $400 can be used to anticipate loss that may
occur. While floating loss is approaching $400, you are run out of available margin, if this happens, your broker is going
to close open positions to prevent your balance falling to negative.
The benefit of leverage : A trader is able to trade much bigger contract size with a relative smaller fund.
With or Without Leverage ?
Equity
Leverage
Contract Size
Margin Req ($)
Margin Req (%)
Profit
Avail Margin
$15,000
1 : 1
$10,000
$10,000*
100 %
$1/pip
$5,000**
$15,000
1 : 100
$10,000
$100
1 %
$1/pip
$14,900
* Margin Requirement ($) = Margin Requirement (%) x Contract Size
$10,000 = 100% x 10,000
** Available Margin to hold loss = Equity – Margin Requirement ($)
$5,000 = $15,000 – $10,000
From the table above, we can see by using Leverage, trader has an opportunity to use the SAME Contract
Size ($10000), but with smaller margin requirement ($100). Potential profit of both cases are also the SAME
($1/pip).
At the other side, leverage can help trader by giving more Available Margin to hold the loss ($14,900 available margin can
hold more loss than $5,000)
Big or Small Leverage ?
Trader
Leverage
Contract Size
Margin Req (%)
Margin Req ($)
Profit
A
1:100
$100.000
1%
$1000
$10/pip
B
1:200
$200.000
0.5%
$1000
$20/pip
C
1:500
$500.000
0.2%
$1000
$50/pip
From the illustration above, we can see by using Bigger Leverage, trader C has an opportunity to use
BIGGER Contract Size ($500.000), with the SAME Margin Requirement ($1000).
Please note : Lot Size (Contract Size) used will affect pip value.
From the example above, it is clearly seen, eventhough Trader A, B, and C have the same Margin Requirement ($1000)
. Trader C have the biggest profit for every pip ($50/pip)
