HomeForex 101The Basics of Forex Trading

# The Basics of Forex Trading

In the Forex market, traders buy and sell currency pairs to make money. By using technical analysis, traders can speculate whether they will go long or short on a currency pair. Before we talk about technical analysis and strategies, we need to lay some ground here and start from the beginning.

## Pips and Basis Points

Pip is the unit of measurement that represents the change in value between two currencies. For example, if EUR/USD moves from 1.2550 to 1.2540, the 0.0010 USD rise in value is 10 pips.

Some pairs like the USD/JPY goes with two decimals instead of 4 decimals. In this case, one pip move would be .01 JPY.

Some brokers quote currency pairs beyond the standard 2 and 4 decimals and use 3 and 5 decimals instead. In this case, the change in value is called pipette instead of pip.

For example, EUR/USD moves from 1.25501 to 1.25508 USD, it is 0.00007 pipettes.

Now, let’s convert the pip value into Percentage and Basis Points:

For example, EUR/USD appreciates 100 pips from 1.1174 to 1.1274,

{(1.1274-1.1174)/1.1174} x 100 = 0.895%, EUR/USD has risen 89.5 basis points.

Therefore, at current prices, 1 pip in EUR/USD is equal to 0.00895 or 1 basis point.

As a rule: A basis point is 1/100th of 1 percent (%) i.e. 1% = 100 basis points or 0.01% = 1 basis point.

Let’s define the bid and the ask price first.

Bid/Ask is a two-way price quotation that indicates the best price at which a security can be sold or bought at a given point in time.

The bid price represents the maximum price that a buyer is willing to pay for security.

The ask price is the minimum price that a seller is willing to receive from this transaction.

A trade occurs after the buyer and the seller agree on a price for the security.

The spread is the difference between the bid and ask prices. In general, the smaller the spread, the better the liquidity.

The spread is an indicator of supply and demand for the financial instrument in question. The more interest the investors have, the tighter the spread.

For example, EUR/USD quote of 1.2550/1.2557 tells traders that they can currently purchase the currency pair at 1.2557 or sell it at 1.2550. The spread between the bid and the ask is 0.0007 or 7 pips.

When trading a 10k EUR/USD lot with a \$1 pip cost, you would pay a total cost of \$7 on this transaction.

## Lot Size

A lot simply means the number of currency units you will either buy or sell a specific security. The standard size for a lot is 100,000 units of currency, a mini, micro, and nano lot sizes are 10,000, 1,000, and 100 units respectively.

For example, let’s say you are using a standard lot size and you decide to buy or sell USD/JPY pair at the exchange rate of 119.20. Let’s calculate the pip value:

(0.01/119.20) x 100,000 = \$ 8.38 per pip.

It is more than likely that as a retail trader, you will be dealing in Mini, Micro and Nano lots. Lots are more for institutional level traders at investment banks and hedge funds.

## Leverage

Leverage involves borrowing money from your broker to invest in the market. It is basically the ability to control a large amount of money using small capital. For example, to buy a position worth of \$100,000, your broker will ask you to deposit a certain amount of money, let’s say \$1000 in your account and the rest of the money will be provided by your broker. In this example, the leverage ratio is 100:1. You are now trading \$100,000 with \$1000.

The \$1000 deposit is what is called the margin. It is the amount of money deposited in your account in order to use leverage.

So if your broker requires 2% margin, you have a leverage of 50:1. If the required margin is 0.25%, you have a 400:1 leverage.

## Margin and Margin Call

With 1% Margin Requirement, this means you only have to put up GBP 1,000 initial margin in order to borrow GBP 100,000 from the broker to trade 1 lot of GBP/USD – 100 times leverage.

If GBP/USD goes up by 1% you will make GBP 1,000 (100% return), if GBP/USD goes down by 1% you will lose GBP 1,000 and therefore 100% loss on your initial margin.

What really matters is the gross exposure you have and the volatility of the assets that you have positions in. Let’s think of this in terms of buying a stock like Apple. If you buy 1,000 shares at \$125 your exposure is \$125,000, if Apple goes down by 1% you lose \$1,250.

It’s the same when trading currencies. We’re simply using a base unit to work out our risk i.e. percentages.

A margin call occurs when the account value falls below the broker’s required minimum value.

For example, let’s assume you have a standard account leveraged 100x and you deposited \$1,000 to manage a \$100,000 trading account. You actually deposited 1% of the entire account size and you borrowed the rest (\$99,000) from your broker.

Therefore, if you lose 1% of your entire trading account, which is \$1,000, you will get a margin call and your account is closed. In order for you to keep trading, you will need to fund your account.

## Types of Orders in Forex

When it comes to trading the forex market, there are more than just buy and sell orders. Based on the location of the current price, a trader has to know what order he or she will need to place on the market. These orders are: market order, buy/sell limit orders, and buy/sell stop orders.

### Market Order

The simplest and easiest order to place in the forex market is the market order. Basically, traders simply click on sell or buy to execute their trades directly on the market at the current market price.

The reason why most advanced traders don’t use market orders is because orders get filled at whatever price is available in the marketplace.

For example, the bid price for USD/CHF is currently at 0.98160 and the ask price is at 0.98208.

If you wanted to buy USD/CHF at market, then it would be sold to you at the price of 0.98208.

In currency pairs with very large spread, you will end up getting your orders filled at much worse price leaving you with less probability of making money, especially if you are a scalper or an intra-day trader.

A limit order is an order placed below current price for a buy position and above current price for a sell position.

A stop order is an order placed above current price for buy positions and below current price for sell positions.

The difference between these styles is based on the length of time that traders keep their trades open. Scalping traders are only holding their positions for a few seconds to a few minutes. Day traders keep their positions for anywhere from a few minutes to hours.

While swing traders hold their positions for a few days. Finally, position traders are holding their positions for anywhere from a few days to several years.

### Scalping

Scalping is a very rapid trading style, and scalpers often make trades within a very short time. This trading style is very demanding and traders need to make immediate trading decisions and act on it without second guess.

Being a successful scalper requires focus, concentration and most importantly stress management. Because they spend a great time in front of their screens looking for short and quick opportunities, they need to be able to manage their level of stress and keep calm no matter what the outcome is.

Day trading style is suited for those who like to open and close trades within the same day. They are often unable to sleep at night knowing that they have an active trade that could be affected by overnight price movements.

Swing trading is compatible with people that have patience to wait for a trade and be able to hold it overnight. So it is not suitable for those who would be nervous holding a trade while they are away from their computer.

This trading style requires a large stop loss and the ability to keep calm when a trade is going through retracements.

Position trading is the longest term trading and often has trades that last for several years. Position trading style is more suitable for the most patient, least excited traders and has a large capital, to begin with.

Note

Just because you lost one or two trades doesn’t mean that you need to change your trading style. This is a beginner’s mistake to keep changing styles. You need to find a trading style that better suits your trading goals and your lifestyle. Then stick to it for at least one to three months to get enough statistical data to assess whether this is working for you or you need to change it.

## Forex Market Hours

The currency market is open 24h a day from Sunday night (10 p.m. GMT) until Friday night (9 p.m. GMT).

The forex market is open 24 hours a day because currencies are needed for international trades and buying/selling products and services all around the world.

The forex market can be split into three main regions: Australia-Asia, Europe and North America.

Each trading day starts with the Asian session, followed by the European and finally, the North American session. As one region’s market closes another opens, or has already opened, and continues to trade in the Forex market. Often these markets will overlap for a couple of hours providing some of the most active Forex trading.

European currencies are most traded from 8 a.m. to 4 p.m. GMT – this is called the London/European session, and from 12 p.m. to 9 p.m. GMT is the North-American trading session.

Although the Sydney session starts at 9 p.m. Sunday GMT, it is too thinly traded, so you could wait for the Tokyo market to open an hour later for the better trading volume.