Currency Trading: Understanding the Basics of Currency Trading
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.
About the author:
Raul Lopez is a full time Forex trader and founder of
http://www.straightforex.com a high quality Forex training company.
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Risk Disclosure: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest / trade in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading.
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