What is Forex (FX)?
Foreign exchange is the largest financial market in the world – transactions worth trillions of dollars take place every day, traded by a global network of banks, dealers and brokers. Due to the sheer volume of currency traders and the amount of money exchanged, price movements can happen very quickly. This means there are many currency trading opportunities, but it also makes forex market incredibly volatile.
Understanding the basics
In order to trade forex, you have to trade two individual currencies against each other (for example EUR/USD – the euro vs US dollar). In this pairing, EUR is known as the base currency, and USD as the quote currency.
You would speculate on whether the base currency will strengthen (appreciate) or weaken (depreciate) against the quote currency. If you think the base currency will appreciate, then you should go long (buy), and if you think the base currency will depreciate, you should go short (sell).
After choosing whether to go long or short, the currencies will fluctuate based on multiple factors until you decide to close the position. This will determine the profit or loss you make on the trade.
What is a Pip?
A pip is a term used in the currency market to represent the smallest incremental move an exchange rate can make. Depending on context normally one basis point is 0.0001, as is the case of EUR/USD, GBP/USD. In example if the EUR/USD moves from 1.2561 to 1.2562 it is one pip.
If you trade the full contract (100k of currency) the EUR/USD and GBP/USD are worth approximate $10. In other words if you have a trade with 50 pips in profit, it means the gain is $500. ($10 per pip x50 pips). If you trade a mini account is 1/10th of the size, 50 pips will worth $50.
Example how to set a position size on your account:
The account size is $2000.
The amount you are risking = 2%, of $2,000 = $40
Value per pip for 1 standard lot on EUR/USD = $10/pip
Stop Loss = 100 pips = $40
Position size 0.04 lot = 40/(100*10).
Different types of orders
1. Market Orders
This order type is often the first execution order that traders come across. Just as its name implies, this is an order that’s executed at market and is immediate. This means that if you want to enter or exit the market instantly, you can use a market order to trade at the next best available price. However, you might want to note that in a fast-moving market where price can change in seconds, the price can alter substantially between the time the order is placed and the time that it’s completed/filled. This is called slippage. The difference between the bid/ask price is known as the spread, which is essentially the broker’s fee/commission.
To set a market order, you have to click on the New Order window and to specify the order execution conditions: the currency pair (USD/CAD in example), the volume, the stop loss and take profit targets. Be sure you set order type Market Execution and select Sell or Buy button open a new order.
2. Pending Orders
A pending order allows traders to buy and sell securities at a pre-defined price in the future. This type of order is used to execute a trade if price reaches the pre-defined level; the order will not be filled if price does not reach this level. There are four types of pending orders available in trading platform Metatrader 4.
To set a pending order, you have to click on the New Order window and change the order type from Market Execution to Pending Order. Right after you choose the Pending Order option, some input fields will appear to specify the order execution conditions: the currency pair, the volume and rate of the position opened, the order type, stop loss and take profit, and, if necessary, comments on the order and the expiration date, after which the pending order will be automatically removed. After setting up the required parameters, press the Place button to place the order with the specified execution conditions. You can see the order you set in the Terminal field, the Trade tab. To change the conditions of the pending order or to delete it, you have to give the order a right click and select Modify or Remove the Order in the pop-up menu.
A take-profit order automatically closes an open order when the exchange rate reaches the specified price threshold. Take-profit orders are used to lock-in profits when you are unavailable to monitor your open positions.
For example, if you are long USD/JPY at 109.21 and you want to take your profit when the rate reaches 110.00, you can set this rate as your take-profit threshold. If the bid price touches 110.00, the open position is closed by the system and your profit is secured. Your trade is closed at the current market rate. In a fast moving market, there may be a gap between this rate and the rate set for your take-profit.
A stop-loss automatically closes an open position when the exchange rate moves against you and reaches the level you specify. For example, if you are long USD/JPY at 107.40, you could set a stop-loss at 107.00 – then, if the bid price falls to this level, the trade is automatically closed. It is important to understand that stop-loss orders can only restrict losses, they cannot prevent losses. Your trade is closed at the current market rate. In a fast moving market, there may be a gap between this rate and the rate you set for your stop-loss. It is in your best interest to include stop-loss instructions for your open positions. Think of them as a very basic form of account insurance.
Influencing factors on the forex market
There are a number of reasons why forex pairs move so much (this movement is known in the industry as volatility). A few volatility-causing factors you should be aware of when forex trading:
- Financial news events
Large financial news events such as government budgets, trade relations, macroeconomic activity, unemployment rates and interest rate announcements can significantly increase volatility in the markets. It can be more apparent in the local currencies where the announcement is being made.
- Political economic stability
The welfare of a nation can have a major impact on the performance of it’s currency. If a country is struggling economically, it’s extremely likely its associated currency also depreciate.
- Natural disasters
As horrible as they are, natural disasters can affect a currency’s wellbeing as well as people’s lives. Should an earthquake or tsunami occur, expect some sort of volatility to be generated in the currency associated with that region.
Examples of Forex trades
The current monetary policy is in favour of a strong dollar and we anticipate a bearish move on the AUD/USD.
We decide to go short 1 lot (100,000 units) of AUD/USD at a price of 0.74500. The margin required to open the position will be (using 200:1 leverage):
100,000 x 0.74500 / 200 = 372.5 USD
After some time the market moves in our direction, and is now trading at 0.73700.
We decide to take our profits and close the position.
The profit made on this position will be:
0.74500 – 0.73700 = 80 pips.
1 lot = 10 USD per pip.
Therefore, the total profit we made is 80 x 10 = 800 USD.
After a positive news update on UK employment, we anticipate a rise in the price of GBP/USD (also known as ‘cable’).
We decide to go long 3 lots of GBP/USD at 1.4020. The margin required to open the position will be (using 200:1 leverage):
300,000 x 1.4020 / 200 = 2103 USD
Straight after we enter the position the market pushes against us and is now trading at 1.3985.We decide to close the position at a loss. The amount we lost is: 1.4020 – 1.3985 = 35 pips.
3 lots = 30 USD per pip.
Therefore, the total loss for this trade is 35 x 30 = 1050 USD.
High Risk Warning
Trading Forex carries a high level of risk since leverage can work both to your advantage and disadvantage. You must be aware of the risks of investing in forex, futures, and options and be willing to accept them in order to trade in these markets. Trading spot currencies involves substantial risk and there is always the potential for loss. Please do not trade with borrowed money or money you cannot afford to lose. Your trading results may vary. Before deciding on trading on margin products you should consider your investment objectives, risk tolerance and your level of experience on these products. Trading Forex may not be suitable for all investors, so please ensure that you fully understand the risks involved, and seek independent advice if necessary.
Information contained in this website is not an invitation to trade any specific investments. Any information contained on this website is provided as general market commentary and does not constitute investment advice. Do not act on this without advice from your investment professional, who will verify what is suitable for your particular needs. Currency trading involves high risk and you can lose a lot of money. Please remember past performance is not an indication of future performance and should not be the sole factor of consideration when making an investment decision. There are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any trading system. No one can guarantee profits or freedom from loss.