Currency Trading Basics

The foreign exchange market is the term given to the worldwide financial market which is both decentralized and over-the-counter, which specializes in trading back and forth between different types of currencies. This market is also known as the Forex market. In recent times, both investors and traders located all around the world have begun to notice and recognize the foreign exchange market as an area of interest, which is speculated to contain opportunity.

However, before considering treading these waters, it is important to first understand how transactions are conducted within the foreign exchange market. It is also necessary to first explain what the basics are of trading foreign currency. Failure to fully and completely understand this art prior to journeying off into this market would render a person lost in a matter of minutes, just where they would never expect it. Thus, this article has been presented, intending to explain currency trading basics thoroughly.

What is traded within the foreign exchange market?
The one instrument that foreign exchange market investors and traders constantly utilize are currency pairs. This is a term used to describe what the rate of exchange for one currency is over another currency. In the whole of the market, the following are the currency pairs that of which are traded most often:

  • EUR / USD – Euro;
  • GBP / USD – Pound;
  • USD / CAD – Canadian Dollar;
  • USD / JPY – Yen;
  • USD / CHF – Swiss Franc; and
  • AUD / USD – Aussie

In the whole of the foreign exchange market, the previously listed currency pairs generate up to 85% of the volume.

If a trader ends up going long or goes ahead and buys the Euro, he or she is also, at the same time, buying Euro and selling the United States Dollar. In the event that this same trader ends up going short or goes ahead and buys the Aussie, he or she will also, at the same time, be selling the Aussie and purchasing the United States Dollar.

In each currency pair, the former currency is the base currency, where the latter currency is typically in reference to the quote or the counter currency. Each pair is generally expressed in units of the quote or the counter currency that of which are needed in order to receive a single unit of the base currency.

To illustrate, if the quote or the price of a EUR / USD currency pair is 1.2545, this would mean that one would require 1.2545 United States Dollars in order to receive a single Euro.

Bid / Ask Spread

It is common for any currency pair to be quoted with both a bid and an ask price. The former, which is always a lower price than the ask, is the price at which a broker is ready and willing to buy, which is the price at which the trader should sell. The ask price, on the other hand, is the price at which the broker is ready and willing to sell, meaning the trader should jump at that price and buy.

To illustrate, if the following pair were provided as such:

EUR / USD 1.2545/48 OR 1.2545/8
Then the bidding price is set for 1.2545 with the ask price set to 1.2548.

The minimum incremental move that of which is made possible by a currency pair is otherwise known as a pip, which simply stands for price interest point. For example, a move in the EUR / USD currency pair from 1.2545 to 1.2560 would be equivalent to 15 pips, whereas a move in the USD / JPY currency pair from 112.05 to 113.05 would be equivalent to 105 pips.

Margin Trading (Leverage)
In other financial markets, it would generally be required to have the full deposit of the amount that of which is traded. However, in the foreign exchange market, all that of which is required would be a margin deposit, with the remainder being granted by the broker.

Some brokers will provide leverage that will rise up to 400:1. In essence, this means only 1/400 in balance is required to open a position, or .25%. The majority of brokers, however, will only offer 100:1, meaning 1% is required in balance in order to open a position.

A typical lot size within the foreign exchange market is roughly $100,000 United States Dollars.

When a trader would desire obtaining a long lot within the EUR / USD currency pair, where the leverage amounts to about 100:1, in order to open such a position would require $1,000 United States Dollars in balance, or 1%.

It is not recommended, of course, to open such a position when the trading balance retains such limited funds. In the event that the trade should go against the trader, the broker will close the position. This will bring the focus onto the next term.

Margin Call
In the event that the balance of a trading account should end up falling below the maintenance margin, which is the capital required to open a position (1% in a 100:1 leverage, 2% in a 50:1 leverage, so on and so forth), a margin call will occur. At the moment that this margin call occurs, the broker will either sell off all of the trades or buy back in the event of short positions. This will theoretically leave the trader with the maintenance margin.

Margin calls generally occur in the event that money management is not applied in a proper manner.

How are the mechanics of a foreign exchange market trade?
To illustrate an example, after extensive analysis, a trader concludes it is likely for the British pound to rise in price. This trader decides it is worth going long and risking 30 pips, intending to wind up being rewarded with 60 pips. In the event that the market goes against this trader’s decision, they will end up losing 30 pips. However, should the market go as intended, they will gain 60 pips.

The British pound has a quote that is precisely 1.8524/27, 4 pips spread. The trader in question will go long at 1.8530, or ask. Once the market either reaches the target or the risk point, the trader will need to sell it at the bid price. To make 40 pips, the profit level would need to be 1.8590. Should the target be hit by the market, then the market has run 64 pips. Otherwise, the market will have run 30 against.

As one may have gathered at this point, it is generally a very good idea in order to fully understand the basics of currency trading, from the very basic concepts to the more complex issues, before deciding to tread the waters of the foreign exchange market. Make sure every single aspect of the subject is mastered, including trading psychology, trade and risk management, as well as everything else, prior to making the decision to opening a live trading account. Best of luck.