GBP USD forex chart

Forex Trader – Trading Principles To Get To Grips With

A forex trader trades the forex market. The forex market refers to the buying and selling of currencies of different denominations for the purposes of: repatriation of foreign funds; speculation; global business. Spot Forex trading refers to forex trading whereby settlement occurs very soon after the trade is agreed.

Who or What Trades Forex

The interbank market does the majority of the business of forex trading. Institutional traders and retail traders are the participants. Retail investors trade forex normally through a margin broker. Margin brokers act as middle-men between the interbank market and the retail trader.

Forex brokers and Leveraged Forex Trades?

A retail forex trader can obtain leverage from his or her margin broker. The broker may offer 50:1 leverage for example. This means that if the retail trader deposits $10000 US in their account, the broker will allow the trader to control a book amount of 50 x $5000 = $500,000 of currency. Many people struggle with understanding this concept. Their inclination is to fear that this automatically means they can lose far more money than they actually have deposited.

However, this is not the case for two reasons. Firstly, the price of forex pairs (e.g. the GBP/USD pair – British pound vs. US dollar) are quoted to the 1/1000 of a cent. So the quote my be: 1.5656/9 meaning that 1.5659 dollars can be sold in return for buying 1 pound or that 1.5656 dollars can be bought in exchange for selling 1 pound. The 0.0003 diference is known as the “bid ask spread.”

This is simpler than it sounds. Here is a forex quote:

GBP/USD   1.5656 (Bid) 1.5659 (Ask)

What this means is that the broker is willing to buy your 1 pound for 1.5656 at that time (you sell your pounds and buy dollars) or alternatively, you can buy pounds (and automatically sell dollars) at the price the broker is “asking” namely 1.5659.

In this case, we have a base currency (the Great British Pound) being quoted against the US dollar. The so-called “exchange rate” at that time is given by the current price. The spread between the bid and ask price is known as the “margin spread” and this is how the broker makes their commission (through the spread).

PIPS in Forex Trading & Why Leverage Is Required For Anyone To Make Any Money

What happens if the price goes up to 1.5656 to 1.5657? It means the value of one pound is now worth 1.5657 which is 0.0001 dollars more than a moment ago! This change in price is known as a change of 1 pip (price interest point). Going back to our original point about leverage and the $10,000 account then. If we have $10,000 being used in a trade and we make a profit of 20 pips, for example, by buying the pound (selling the dollar) at 1.5656 and then selling the pound (buying the dollar) – i.e. closing the trade – at 1.5676 – we have made a profit of 0.0001 x 20 = 0.0020 which is less than a single cent for the trade!

Nobody could get rich this way, not even the banks. What happens if we have 50:1 leverage given to us by the broker though? It means we can control 50 x our deposit as stated. This allows us to trade a bigger position size than we actually have in physical capital. How can we do this?

Because, our $10,000 collateral gives enough leeway for the market to swing a large number of pips in the opposite direction to which we want it to, without going below zero. Therefore, the transaction can take place in the broker’s books (or in the market) without you or the broker being overly concerned about it.

Why? Firstly, let’s say you use all of your $10,000 deposit PLUS the leverage the broker is offering you – 50:1 to control $500,000 of currency (known as one half of one standard lot – 1 lot = 100,000 units of currency). Controlling this amount, when the price moves from 1.5656 to 1.5657 this incremental change is worth $5 to you in the trade.

The market is going to have to move 10,000/5 = 2,000 pips (aka points) if your account is to be wiped out completely. The market does not move this amount of pips in several months sometimes and secondly, if your account were to get dangerously low, your broker will likely issue a “margin call” and liquidate your position rather than see you go into the red beyond your deposited means.

Putting It Together – A Brief Summary Of Forex Trading For Forex Trader

Let’s recap. The forex market is made up of institutional traders and retail traders who are trading in “currency pairs” (as opposed to stocks, soybeans, pork bellies, oil, palladium etc etc). Being the largest market in the world, the turnover daily is a staggering 2 trillion dollars approximately. The reason forex trading needs to occur is due to currency repatriation, global business transactions (including hedging) and speculative trading. Currency pairs can be denominated in a base currency other than the dollar (e.g. EUR/USD) or in dollars (e.g. USD/JPY). The vast majority of forex trades include the dollar in them. 1 pip is 0.0001 units in forex trading.

Brokers provide leverage to retail traders e.g. 25:1 or 200:1 leverage allowing trades to be able to make money which is worth trading for. SPOT FX deals are settled normally a couple of working days after the trade is agreed. Money can be made buying the base (left hand side) currency, when the price quoted goes up or selling the base currency, when the price quoted goes down. When you buy the base currency, you automatically sell the currency on the right hand side and vice versa when you sell the base currency. This is why it is said currencies are traded in pairs.

On this last point, actually, all financial instruments can be looked at as being traded in pairs. For example, let’s say you buy XYZ company’s stocks for $3. Effectively, you could say you “sold” your US dollars in exchange for buying XYZ company’s stock. So the pair is XYZ company’s stock (the asset) vs. the USD (cash).

Questions, queries, comments, corrections about forex trading or being a forex trader

If you have any questions or want clarification or to correct me on any of these points, please do feel free to do so using the comments box below.

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