What is Forex Trading? Forex Trading is the buying of one currency and the selling of another concurrently. The Foreign Exchange market is the world’s largest financial market, with over $3 trillion traded daily. By way of comparison, the Forex market is 100 times larger than the New York Stock Exchange, and triple the size of the US Equity and Treasury markets combined. Forex has no central trading location, meaning that transactions are conducted via telephone or internet by a global, decentralized network of banks, multinational corporations, importers and exporters, brokers and currency traders. This is in contrast to a stock market which is a centralized equities trading location.
What are currency pairs?
In the currency market numerous currencies are traded more frequently than others, making them more liquid and easier to buy and sell. Due to economic situations, the U.S Dollar has been the most valued currency over the last couple of decades, making it the most traded currency. Generally, the major currencies—the British Pound (GSP), the Euro (EUR), the Japanese Yen (JPY), and the Swiss Franc (CHF)—are traded against the US Dollar (USD).
To help us understand which currencies are more popular than others, currency pairs are divided into different categories.
Majors: Liquid currencies that trade against the dollar.
Crosses: Popular currencies that trade against each other, not including the USD.
Exotics: Currencies that represent emerging economies. These currencies are often unique to individual countries.
The currency pairs are expressed with a base currency as the first part of the pair, followed by the quote or secondary currency. For example, USD/JPY would be the US dollar as the base against the Japanese Yen as the quote.
Below is a list of commonly traded currency pairs:
EUR/USD, GBP/USD, USD/JPY, AUD/USD, NZD/USD, USD/CAD, USD/CHF
What is the Bid/Ask Price?
Accompanying the currency pair is the quota, or bid/ask price. This is expressed in the following format: EUR/USD: 1.2836 1.2839.
Bid price: The first number in the series represents the bid price, the cost of selling the Euro against the Dollar. This is the price at which an investor, trader or institution is willing to buy €1 (Bid for the currency)i.e., €1 is selling at $1.2836.
Ask Price: The second number is the ask price, the cost of buying the Euro against the dollar. This is the price at which an investor, trader or institution is willing to sell €1 (Their asking price) i.e., €1 can be bought at $1.2839.
Spread: The difference between the Bid price and Ask price is called the pip spread.
A trade is completed when the Bid price meets the Ask price, i.e., when the buyer and seller both agree at a price for the transaction. In the above example, the spread is 1.2839 - 1.2836 = 0.0003 = 3 PIPS. The smallest price change a currency can move is called a PIP.
A trade is completed when the Bid price meets the Ask price, i.e., when the buyer and seller both agree at a price for the transaction.
High: The highest price the currency pair traded that particular day. This is also known as an intraday high.
Low: The lowest price the currency pair traded that particular day. This is also known as an intraday low.
How does Forex Trading work?
To illustrate how a deal works and how we make a profit or a loss from a deal, we shall use the EUR/USD pair from the above example. When the bid/ask price is EUR/USD: 1.2836 1.2839, suppose the trader assumes that the Euro is going to strengthen against the Dollar and so he decides to buy a dealsize of €10,000 by selling an equivalent amount of Dollars. Since he needs to sell $1.2839 to buy €1, he buys €10,000 by selling $12,839 as shown below:
€10,000 * 1.2839 (ask price) = $12,839
Now, let us assume that the trader was correct and the Euro actually strengthens against the Dollar and the bid/ask price becomes EUR/USD: 1.2849 1.2852 after some time. At this point the trader sells his Euros and buys Dollars. Now, with the changed price, he can sell €1 for $1.2849. Hence he sells the €10,000 at $12,849 as shown below:
€10,000 * 1.2849 (bid price) = $12,849
His profit = $(12,849 - 12,839) = $10
Whats the big deal? Its only $10 at an investment of $12,839.
This is where the trick is. In Forex trading you do not actually need to invest $12,839 to open a deal worth that value. Your investment is leveraged. Most platforms offer leverage your investment to at least 200 times, i.e., if you invest $100, you can open a deal worth $20,000.
In the above example, the difference between the cost price and selling price for the trader was 1.2849 - 1.2839 = 0.0010 = 10 PIPs. Hence in the EUR/USD pair, 10 PIPs = $10 i.e., 1 PIP = $1 if the deal size is €10,000. the vlaue of each PIP depends upon the deal size. Had the deal size been €20,000 each PIP would be worth $2 whereas for a deal size of €2,000, 1 PIP would be equal to $0.20.
Formula:
Value of each PIP in the secondary currency = Deal size/10,000
This formula is only for currencies with 4 digits after the decimal point as in the EUR/USD pair.
Example: For the EUR/USD pair, €10,000/10,000= $1 per PIP
Hence higher deal size means higher returns but please note that it also means higher losses if the deal goes wrong. Let us assume in the above example, the trader waited longer and sold the €10,000 when the price reached EUR/USD: 1.2939 1.2942. His profit would be $(1.2939 - 1.2839) * 10,000 = $ (0.0100 * 10,000) = $100. But if his understanding had been wrong and suppose the Euro weakened against the Dollar and after some time the prices became EUR/USD: 1.2789 1.2792. His loss would have been $(1.2839 - 1.2789) * 10,000 = $(0.0050 * 10,000) = $50.
On the other hand, had the deal size been €2,000 the profit would have been $20 but at the same time the loss would have been only $10. Hence, the deal size and the wisdom of when to enter and exit the trade are the two key aspects to master if one wants to become a successful Forex trader.
Word of Caution:
For a retail trader with an investment of $100, small deal size and small PIP difference is the way to go. You should open a deal size of not more than €3,000 and should take the profit in at small differences in PIP. For a deal size of €2,500, one PIP is worth $0.25. With a low deal size, you profit less but you loose less as well. Remember that the €10,000 deal could have lost you all your investment.
Disclaimer:
The above is my personal viewpoint about Forex trading. This is no Forex Bible. Since I have no claims on the profit you make from the above info, I shall have no responsibilties and liablities for the loss you sustain. Trading is the individual’s decision and how he does it is finally his reckoning.
