How Trading Works and Terminology
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How Trading Works
So how does the actual trading work? A complete transaction is the buying of one currency and selling of another at the same time. We will be focusing on spot transactions in these lessons and other forms of Forex transaction (i.e. futures, options) will not be covered. The technical definition for a spot contract is a transaction at the current market rate with a settlement that takes place within two business days. However, in a practical sense, when trading Forex, a position is opened at the current rate and can then be closed any time afterwards, at that next moment's rate. Positions that are not closed within the two business days are automatically "rolled over", meaning the Forex dealer with which the position is open will keep automatically renewing your spot contract for you until it is closed.
Going Long or Short
A long position is a situation in which one purchases a currency pair at a certain price and hopes to sell it later at a higher price. This is also referred to as the notion of "buy low, sell high" in other trading markets. In Forex, when one currency in a pair is rising in value, the other currency is declining, and vice versa. If a trader thinks a currency pair will fall he will sell it and hope to buy it back later at a lower price. This is considered a short position, which is the opposite of a long position.
On every exchange, a trader has a long position on one currency of the pair and a short position on the other currency. A trader defines his or her position as an expression of the first currency of the traded pair. The first currency in a pair is known as the base currency. The second currency in the pair is called the counter currency. When a trader buys the base currency he or she takes a long position on a pair, if a trader sells the base currency he or she shorts the pair. Let’s look at a Forex chart and visualize this idea.
The current exchange rate is shown as a brown line with the pair’s price in a brown box. In the above chart, the current rate (120.93) for the USD/JPY pair is the amount of Yen it takes to exchange for 1 Dollar. Forex notation is a little awkward as the rate is equivalent to how much of the counter currency (second in the pair) is required to exchange for 1 unit of the base currency (first in the pair). Therefore, the notation is upside down from the normal logic of using a fraction. When the value of the base currency, here the Dollar, is rising, the rate will be moving upwards (seen as blue candles). If the rate changes from 120.93 to 121.50, it will take more Yen to buy the same amount of Dollars. When the situation is reversed, the Japanese currency is doing better and the pair's price will fall (seen as red candles). It will take less Yen to buy the same amount of Dollars.
Let’s say the trader buys the Dollar while selling Yen at the current rate of 120.93. The trader is therefore buying or longing the USD/JPY pair. If the trader was to sell the Dollar and buy Yen then he or she would be selling (shorting) the pair. This system of terminology is used in order to avoid confusion about which pair is being bought or sold. By taking a long position on the pair, the trader will wish to sell the Dollar back versus the Yen at a higher price, say 121.50, a change of 57 "points".
What is a pip?
A change in price of one "point" in Forex trading is referred to as a pip, and it is equivalent to the final number in a currency pair’s price. For pairs that involve the Yen (like in our USD/JPY example), a pip is counted from the second decimal place, 120.94. For all pairs that don’t involve the Japanese Yen a pip is the fourth decimal place, 1.3279. For the EUR/USD pair that rate would mean that it takes 1.3279 Dollars to get 1 Euro. The value of a pip will be explained on the next page when we discuss margin and leverage.
More Trading Terminology and the Spread
A bid price is the rate at which the market is prepared to buy a specific currency pair in the Forex trading market. This is the price that a trader will receive when selling (shorting) a currency pair. An ask price is the rate at which the market is ready to sell a particular currency pair. This is the price that a trader will have to pay in order to buy (long) the currency pair. The bid/ask combination comprises a quotation, which is based on a floating exchange rate. The quotation lists the bid price first, then the ask price. For the USD/JPY pair the quote will be 120.93/96.
The disparity between the bid and ask is known as the spread, which reflects the difference between the rate offered by a market maker to sell a currency pair and the rate at which the market maker will buy the pair. The value of the spread is greater for currencies that are traded less frequently on the market than for the cluster of the major trading currencies. Contrary to stock market firms, Forex market makers generally do not charge a commission for every transaction, and instead obtain their compensation from the spread.
Explanation of Margin and Leveraged Trading
Now that we know some of the basics of Forex terminology we need to discuss the idea of leverage and how pips are valued. The Forex market is exciting and accessible to small retail traders because of the industry’s high leverage options. Leverage gives a trader the ability to increase the potential return on an investment. Leverage works both ways however; it increases potential returns, but it also increases potential risk. Therefore leveraging magnifies both gains and losses.
Contract Sizes and Pip Values
Leveraging a position involves putting down collateral, known as margin, to take on a position that is larger in value. Currency pairs are usually traded in 100,000 unit standard lots or 10,000 unit mini lots. This means that the trader buys 100,000 of the base currency, while selling the equivalent number of units of the counter currency as dictated by the current exchange rate. When the ask price for EUR/USD is 1.2500, 100,000 Euros are bought while 125,000 Dollars are sold. For a standard contract (1 Lot) in which the USD is the counter currency 1 pip will equal $10 ($1 for a mini lot). For all other pairs exact pip values are slightly different and range from $8 to $10.
Leverage
The above figures appear to put Forex out of reach for small and medium traders. Although this was the case historically, regulatory modernization has allowed smaller sized traders to participate in Forex by offering high-leverage trading. A stock broker might offer 2:1 leverage, meaning that you would need to have $500 in your account to buy $1,000 worth of stock – in the Forex market, traders trade with leverage of 50:1, 100:1, 200:1 or even higher depending on the broker and regulations. At 100:1, you would need to have $1,000 in your account in order to buy one standard lot of EUR/USD. With a leveraged position, a Forex trader magnifies the potential gains from any price movements, however, as was mentioned before, losses are magnified by the same degree.
High-leverage trading is the essence of what distinguishes retail Forex from other markets.
How is this possible? In the Forex market, when trading the established currencies that CMS Forex offers, the amount that a currency changes in any given day is quite small. A one cent (or approximately 100 pip) change in the value of a currency is considered a large move. Therefore Forex dealers can afford to hold a fairly small amount of collateral for any given position.
Margin Call
If the market moves against a trader resulting in losses such that the trader lacks a sufficient amount of margin, there is an automatic margin call. The Forex dealer closes the trader’s positions and limits the losses for the client because this stops the account from turning into a negative balance.
Tying Everything Together in an Example
Let's take a trader with $2,000 in his account, which is his total balance or equity. Our trader buys 1 Lot of USD/JPY at a price of 97.50 (1 US Dollar buys 97.50 Yen) with the 100:1 maximum leverage. The trader's utilized margin is $1000 and he or she has $1000 of floating equity or unused margin. If the trader was to close the position right away, the utilized margin, the $1000 collateral, would return back to the total equity and he or she would still have $2,000 in the account, minus some transaction costs because of the spread which is usually 2-5 pips.
Now let's say the same trader keeps his 1 Lot Buy position of USD/JPY open. If the position moves in the trader's favor, the gains are added to the floating equity in the trader's account. Likewise if the position goes against the trader the losses are subtracted from the account's floating equity. These floating gains or losses are realized when the trader closes the position (or the position triggers a margin call).
If the price moves 100 pips in the trader's favor (the exchange rate moves upwards one Yen to 98.50), then the trader would make a $1,000 gain ($10 per pip × 100 pips). The trader has effectively made a 50% return on his or her $2,000 account, or a 100% gain on the $1000 margin. Conversely, if the direction of the market had gone at least 100 pips against the trader, his or her position would have been closed due to a margin call when the floating equity reaches $0 from $1000. The margin call comes as the account's total equity drops below the $1000 margin requirement. The trader would have a loss of approximately $1000, or 50% of his or her initial account, and about $1000 - the original margin requirement, remaining in the account.
Risk Management
One should consider the risk involved in trading on the forex market. The trader is free to decide whether to take a conservative or a risk-taking approach in making trades. Conservative trading means placing fewer trades over longer periods, with smaller lot sizes, strict risk management, and modest profit targets.
One may use limit and stop orders to decrease the involved risk in trading. When placing a market order, many experienced traders already know the levels at which they will want to exit the trade. The 24 hour nature of the Forex market makes it difficult for a trader to make timely trading decisions, since large market moves may happen while he or she is away. Limit and stop orders automatically close out open positions (or open new ones) when price reaches a certain level.
Limit orders are designed to take gains on a position by closing it out at a predetermined price. For a long position, a limit order is placed above the current price. If a trader holds a short position, then a limit order will be placed below the current price.
A stop order may be used to minimize losses. For a long position, a stop order is placed below the current price. If a trader holds a short position, then a stop order will be placed above the current price. Also known as a "stop-loss order", its purpose is to close out a position in which the market is moving against you, limiting your losses on a trade.
Example: Euro vs US Dollar, December 7th.
Lets look at the figure above to examine a position that has both a limit order and a stop order attached to it. The pair being observed here is the EUR/USD. The position is a Buy, or Euro Long.
The limit order is placed at 1.3320 in case the pair moves upward and would close out the trade at a profit. The stop order is located at 1.3270 in case the trade moves against the direction of the position, and would close out the position at a loss. Closing the position stops any further losses if the price continued to head downwards.
Next lesson will take you through two sample trades to show how the value of positions changes over several days.
It should be noted that it is the policy of Market Makers to attempt to honor all stop and limit orders up to 10 lots in size. However, for larger orders, and during extraordinarily volatile market conditions, it may become impossible to execute a stop or limit order at the intended price, and the next available price may be used to fill the market order.
