Foreign exchange trading was once just something that people had to do when traveling to other countries. They would exchange some of their home country’s currency for another and endure the current currency exchange rate.
These days, when you hear someone refer to foreign exchange trading, they are usually referring to a type of investment trading that has now become common. Traders can now speculate on the fluctuating values of currencies between two countries.
It’s done for sport and profit.
HOW DOES FOREX TRADING WORKS?
When you open a forex position, you are buying one currency while simultaneously selling another. Read on to learn about forex trading basics and how a forex trade works: including currency pairs, the spread, pips and leverage.
Forex trading always involves selling one currency in order to buy another. For this reason, they are quoted in pairs that show which currency is being bought and which is being sold. Each currency in the pair is listed in the form of its three letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself.
GBP/USD, for instance, is a currency pair that involves the Great British pound and the US dollar. In this pair, you are buying pound sterling by selling US dollars.
Base and quote currency
The first currency listed in a forex pair is called the base currency, and the second currency is called the quote currency. The price of a forex pair is how much one unit of the base currency is worth in the quote currency.
So GBP is the base currency and USD is the quote currency. If GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.
If the pound rises against the dollar, then a single pound will be worth more dollars and the pair’s price will increase. If it drops, the pair’s price will decrease. So if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (going long). If you think it will weaken, you can sell the pair (going short).
The spread is the difference between the buy and sell prices quoted for a forex pair.
Like many financial markets, when you open a forex position you’ll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.
What are Pips?
When a forex pair increases or decreases in price, that movement is measured in units called pips. A pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35471, then it has moved a single pip.
The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip.
The decimal places shown after the pip are called fractional pips, or sometimes pipettes.
What is leverage in forex?
Leverage allows you to get exposure to large amounts of currency without having to commit too much capital.
A single pip is a very small unit of movement, and while forex pairs tend to be very volatile they often move in relatively minor increments. For this reason, forex traders will either have to trade large batches known as lots, or take advantage of leverage.
What is a lot?
A standard lot is 100,000 units of currency. Alternatively, you can sometimes trade mini lots and micro lots, worth 10,000 and 1,000 units respectively.
Individual traders don’t necessarily have 100,000 pounds, dollars or euros to place on every trade, so many forex trading providers offer leveraged trading.
The Benefits of Leveraged Trading
Leverage allows you to open a position without having to pay its full value upfront. A trade on EUR/GBP, for instance, might only require 0.5% of the total value of the position to be paid in order for it to be opened.
When you close a leveraged position, the profit or loss is based on the full size of the trade. While that does offer a chance of higher profits, it also brings the risk of amplified losses: including losses that can exceed your deposits.
It seems like something that most people would find easy, except, in this particular industry, there is a high rate of failure among new traders. Even traders that are aware of that tend to start out with the attitude of “It happened to them, but it won’t happen to me.” In the end, 96 percent of these traders walk away empty handed, not quite sure what happened to them, or maybe even feeling a bit scammed.
Forex trading is not a scam; it’s just an industry that is primarily set up for insiders that understand it. The goal for new traders should be to survive long enough to understand the inner working of foreign exchange trading and become one of those insiders.
The number one thing that hangs most traders out to dry is the ability to use forex trading leverage. Using Leverage allows traders to trade on the market with more money than what they have in their account.
For example, if you were trading 2:1, you could use a $1,000 deposit, to control $2,000 of currency on the market. Many forex brokers offer as much as 50:1 leverage. New traders tend to jump in and start trading with that 50:1 leverage immediately without being prepared for the consequences.
Trading with leverage sounds like a really good time, and it’s true that it can increase how easily you can make money, but the thing that is less talked about is it also increases your risk for losses.
If a trader with $1,000 in their account is trading with 50:1 and trading $50,000 on the market, each pip is worth around $5. If the average daily move is 70 to 100 pips, in a day your average loss could be around $350. If you made a really bad trade, you could lose your entire account in 3 days, and of course, that is assuming that conditions are normal.
Most new traders being optimistic might say “but I could also double my account in just a matter of days.” While that is indeed true, watching your account fluctuate that seriously is very difficult to do. Many people start out assuming that they can handle it, but when it comes down to it, they don’t, and forex trading mistakes are made.
Assuming that you can manage not to fall into the leverage trap, you’ll need to have a handle on your emotions. The biggest thing that you’ll tackle is your emotion when trading forex. The availability of leverage will tempt you to use it, and if it works against you, your emotions will have your vision upside down, and you will probably lose money. The best way to avoid all of this is to have a trading plan that you can stick to. Not only should you have a trading plan, but you should keep a forex trading journal to keep track of your progress.
You might feel when looking around online, that other people can trade forex and you can’t. It’s not true; it’s just your self-perception that makes it seem that way. A lot of people that are trading foreign exchange are struggling, but their pride keeps them from admitting their problems, and you’ll find them posting in online forums or on Facebook about how wonderful they are doing when they are struggling just like you.
Winning at trading forex online is an achievable goal if you get educated and keep your head together while you’re learning. Practice on a forex trading demo first, and start small when you start using real money. Always allow yourself to be wrong and learn how to move on from it when it happens. People fail at forex trading every day for lack of ability, to be honest with themselves.
If you learn to do that, you’ve solved half of the equation for success in forex trading.