FOREX Basics

FOREX Basics

"Forex" stands for foreign exchange; it is also known as FX. It is the buying and selling of currencies. Unlike stocks or futures, there is no centralized exchange for Forex. All transactions happen via phone or electronic network. Because of this, Forex is among the most liquid of trading instruments. In fact, the daily trading volume of currencies is $ 3.2 Trillion – which is more than all other world market exchange trading combined!

More than 85% of Forex trading volume occurs in the “Major” currencies: US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.

In a Forex transaction, currencies trade in pairs. Therefore, a trader buys one currency while simultaneously selling its pair. That is, a trader exchanges the sold currency for the one being bought. So when a trader trades Euro-US Dollar (EUR/USD), the trader is actually exchanging the Euro for the US Dollar or vice versa. And when a trader trades US Dollar / Japanese Yen (USD/JPY), the trader is actually exchanging the US Dollars for Japanese Yen or vice versa.

The chart below displays some major and minor currency pairs and their associated trading terminology.

Symbol		Currency Pair		Trading Terminology
GBPUSD		British Pound / US Dollar		"Cable"
EURUSD		Euro / US Dollar		"Euro"
USDJPY		US Dollar / Japanese Yen		"Dollar Yen"
USDCHF		US Dollar / Swiss Franc		"Dollar Swiss", or "Swissy"
USDCAD		US Dollar / Canadian Dollar		"Dollar Canada"
AUDUSD		Australian Dollar / US Dollar		"Aussie Dollar"
EURGBP		Euro / British Pound		"Euro Sterling"
EURJPY		Euro / Japanese Yen		"Euro Yen"
EURCHF		Euro / Swiss Franc		"Euro Swiss"
GBPCHF		British Pound / Swiss Franc		"Sterling Swiss"
GBPJPY		British Pound / Japanese Yen		"Sterling Yen"
CHFJPY		Swiss Franc / Japanese Yen		"Swiss Yen"
NZDUSD		New Zealand Dollar / US Dollar		"New Zealand Dollar" or "Kiwi"
USDZAR		US Dollar / South African Rand		"Dollar Zar" or "South African Rand"
GLDUSD		Spot Gold		"Gold"
SLVUSD		Spot Silver		"Silver"

Calculating Profit and Loss

Calculating Profit and Loss

Example 1:

Imagine the current bid/ask for EUR/USD is EUR/USD: 1.2836/39, meaning a trader can buy 1 euro for 1.2839 or sell 1 euro for 1.2836.

Suppose a trader decides that the Euro is undervalued against the US dollar and expects the value of the Euro to rise. To execute this strategy, a trader would buy Euros (simultaneously selling dollars), and then wait for the exchange rate to rise.

Therefore, the trader places the order to buy 100,000 Euros and pays 128,390 dollars (100,000 x 1.2839) for that order. Remember, at a leverage rate of 400:1, the traders deposit would be approximately $321 for this trade.

As expected, the Euro strengthens to 1.2842/44. Now, to realize the profits, the trader places an order to sell 100,000 Euros at the current rate of 1.2842, and receive 128,420 dollars for that trade.

The trader bought 100k Euros at 1.2839, paying $128,390. Then the trader sold 100k Euros at 1.2842, receiving $128,420. That is a difference of 3 pips, or in dollar terms ($128,420 – 128,390 = $30).

Total profit = US $30 on a deposit of $321

Example 2:

Now in this example, imagine the trader once again buys EUR/USD when trading at 1.2836/39. Just as before, the trader buys 100,000 Euros and pays 128,390 dollars (100,000 x 1.2839).

However, the Euro weakens to 1.2833/36. Now, to minimize loses, the trader sells 100,000 Euros at 1.2833 and receives $128,330.

In this case, the trader bought 100k Euros at 1.2839, paying $128,390 and sold 100k Euros at 1.2833, receiving $128,330. That is a difference of 6 pips, or in dollar terms ($128,390 - 128,330 = $60).

Total loss = US $60

Orders and Trades

Orders and Trades

Generally speaking, there are three types of Forex orders:

1. Market order – an order to buy or sell a currency

2. Limit order – an order to capture gains from advantageous market movements

3. Stop order – an order to forego further losses from disadvantageous market movements

If a trader believes the value of a base currency will increase relative to its pair, the trader should place a Market Order to buy the currency at its “Ask” price. However, in order to protect against the risk of significant losses, a prudent trader will simultaneously place a Stop Order to sell the currency if the “Bid” price drops to a certain level. In addition, in order to capture profits, a trader will often place a Limit Order to sell the currency if the “Bid” price rises to a certain level.

In contrast, if a trader believes the value of a base currency will decrease relative to its pair, the trader should place a Market Order to sell the currency at its “Bid” price. However, in order to protect against the risk of significant losses, a prudent trader will simultaneously place a Stop Order to buy the currency if the “Ask” price rises to a certain level. In addition, in order to capture profits, a trader will often place a Limit Order to buy the currency if the “Ask” price drops to a certain level.

Therefore, prudent Forex trading would suggest that every “buy” order be coupled with two “sell” orders; and every “sell” order be coupled with two “buy” orders.

Candlestick Charts

Candlestick Charts

A candlestick chart shows how currency pairs fluctuate in relative value over time. The x axis shows time in what ever increment a trader wants to see it. It could be minutes, hours, days or even weeks. The y axis shows the value of one base currency unit relative to the other currency in the pair. The candlestick chart below shows EUR/USD at five minute intervals over four hours.

The body of the chart shows blue and red rectangles - which are the "candlesticks". When the candlestick is blue, it means the value of the base currency has increased relative to its pair in that time interval. For blue candlesticks, the bottom edge is the opening price and the top edge is the closing price in the time interval.

When the candlestick is red, it means the value of the base currency has decreased relative to its pair in that time interval. For red candlesticks, the top edge is the opening price and the bottom edge is the closing price in the time interval.

The thin lines protruding from the top and bottom of the rectangles are called “wicks” or “tails” or “shadows”. They display the high and low prices of the base currency relative to its pair in that time interval.

Most often, we see “Bid” charts – which shows the price of selling the base currency relative to its pair. But a trader can also choose to display "Ask" charts - which show the price of buying the base currency relative to its pair.

Leverage & Margin

Leverage & Margin

Leverage trading, or trading on margin, means a trader is not required to put up the full value of the position. But there are some important distinctions between trading stocks on margin and trading Forex on margin.

When stocks trade on margin, the leverage ratios are in the range of 2:1 or 4:1 – meaning a trader would only have to deposit $10,000 to the trader’s account in order to trade stocks worth $20,000 or $40,000 respectively. However, this kind of leverage requires the stock trader to be approved for “credit” for the amount invested that is in excess of what is deposited. Moreover, if the value of the stocks falls to a certain level, a stock trader trading on margin may have to pay additional funds than originally deposited to cover the losses.

Forex trading offers more leverage than stocks or futures - up to 400 times the value of the deposited funds in the Forex trading account. Therefore, at 400:1 leverage, a trader need only put up $25 to trade $10,000 worth of a currency. However, unlike trading in stocks, Forex traders do not need credit approval to trade on margin. If the value of the Forex positions falls to a certain level, ICM will close out all positions so a trader will never owe more money than what the trader initially deposited.

Keep in mind that increased leverage increases both a trader's opportunity and risk. For example, at 400:1 leverage, a change of 1% in the underlying value of the trade will result in a gain or loss of 400% on the underlying deposit.

Currency Quotes

Currency Quotes

Reading a foreign exchange quote is simple if you remember two things:

1. The first currency listed is the base currency

2. The value of the base currency is always 1

A currency pair quote is comprised of a bid/ask price expressed in the following format:

EUR/USD: 1.2836 / 1.2839 or EUR/USD: 1.2836/39

The first number in the series represents the bid price, the cost of selling the Euro against the Dollar, or going ‘short' on the Euro.

The second number represents the ask price, the cost of buying the Euro against the dollar, or going ‘long’ on the Euro.

The difference between the ask price and the bid price is called the pip spread.

What is a pip?

A pip (or “percentage in point”) is the smallest unit of measure for any currency. In most currencies, this is the fourth digit after the decimal point and is equal to 1/100th of 1% or .0001. So, using the example above (EUR/USD: 1.2836 1.2839), the spread is 3 pips (39 – 36).

NOTE: For Japanese yen, pips refer to the second digit after the decimal point. This is the only exception among the major currencies.

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