What is Forex? Introduction For Beginners
4 mins read ● Last Updated: 3 November 2023
Written by || Nick Quinn
If you’ve ever traveled to another country, the chances are you have visited a currency exchange booth and exchanged your money into the currency of the country you were visiting. If that’s you, you’ve participated in forex!
But before you embark on the forex trading journey, what exactly is forex?
What is the Forex Market?
Forex market is short for ‘foreign exchange market’ (sometimes abbreviated to just FX market). It is a global marketplace where one currency is exchanged for its equivalent value in another currency. Simply put, it’s the market where national currencies are traded.
The forex market is the most liquid and largest financial market globally, with an average daily trading volume exceeding $7.5 trillion.
All the world’s combined stock markets don’t even come close to the total turnover of the Foreign Exchange markets. Unlike other financial markets like the stocks and commodities market, Forex is a decentralized market, and currency pairs are traded worldwide. This means that there is no central location, and there are no formal exchanges where transactions take place.
What’s more? Forex is a market that rarely closes! The currency markets are open 24 hours a day and five days a week, only closing down during the weekend. So, unlike other markets like the stock and bond markets, the Forex market does NOT close at the end of each business day.
How Does the Forex Market Work?
The Forex market can be broken up into four major trading sessions. The Sydney session, the Tokyo session, the London session, and the New York session. Some forex brokers and forex traders prefer to differentiate sessions by continent names. This is known as the ‘Forex 3-session system’. These sessions consist of the Asian, European, and North American sessions (Asian and Australian sessions are often combined into one).
In terms of the specifics, the Forex market opens in New Zealand on Monday morning, which is called the Sydney session. It makes no sense, but we don’t make the rules. It is open daily throughout the week until it closes on Friday at 5 p.m. EST. Other than the weekends, there are just two public holidays when the entire Forex market is closed: Christmas and New Year’s Day.
How Does Forex Trading Work?
Now that you understand how the forex market works let’s show you how forex trading works:
Forex trading can mean two things. It can mean the actual exchange of one currency for another. For instance, you want to travel to Japan from the United States. You have US Dollars on you, but they spend Yen in Japan. So, you must exchange your dollars for what it’s worth in Japanese Yen
To know what your dollars are worth in Japanese Yen, there’s something called an exchange rate. An exchange rate is the predetermined price of one currency when compared to another. For instance, the exchange rate of USD to JPY as of the time of this writing is 151.19. This means for every dollar, you can exchange it for 151.19 Yen.
One way to put it us that you bought 151.19 JPY using 1 USD. You can also see it as selling your 1 USD to buy 151.9 JPY.
Exchange rates fluctuate a lot depending on many factors. Some of these factors include political climate, macro and microeconomics within the involved countries, monetary and fiscal policies such as interest rates, and so on.
That is one part of forex trading.
The other part of sweet bonanza involves taking advantage of this constant price fluctuation to make a profit. Someone who does this kind of trading is called a forex trader. Traders would speculate the future value of an exchange rate between two currencies. If they’re right, they make a profit, And if they’re wrong, they make a loss.
This forex trading style involves the use of trading strategies and analysis systems to try and predict what the value of the exchange rate will be in the future. You’ll often see them staring at candlestick charts of red and green bars that have little sticks above and below them. Many even draw up a robust trading plan, doing some technical analysis, all in a bid to predict future price movements.
This second type of forex trading is most common among individuals. To start trading this way, you need to open a forex trading account with a reputable online broker in the market. A forex broker gives you access to the forex markets and enables you to place orders and execute your trades on a trading platform.
Key Takeaways
- The forex market is the over-the-counter market where currencies are traded.
- It’s open every day of the week except on weekends.
- Forex trading always cycles within three sessions: Asian, London, and New York sessions.
- Forex trading involves buying and selling one currency with another. It is the act of exchanging one currency for the other. It can also mean speculating on the future values of the exchange rates between currencies.
There you go. Your brief introduction to forex trading. Now that you know what the forex market is about, do you think trading forex could be your thing? Before you answer the question, take a look at our next lesson which talks about the forex market participants.
Who Participates in the Forex Market?
5 mins read ● Last Updated: 11 December 2023Written by || Shain Vernier
Just as buyers and sellers are the participants in a typical market, the forex market also has its participants. You see, the Foreign Exchange market is a world unto itself, with various players, from individual traders like you, all the way up to deep-pocketed commercial and central banks.
Depending on who you ask, there can be as many as 10 participants in the forex market. But we can put them all into five major categories.
Let’s see them:
Who Are the Forex Market Participants?
The following are the major forex market participants:
1. Commercial Banks
At the top of the Forex market ladder are the largest banks in the world, collectively known as the interbank market or flow monsters.
These commercial banks are responsible for most of the daily trading volume in foreign exchange transactions and include banks like Citi, JPMorgan, Barclays, Goldman Sachs, Deutsche Bank, and any other major bank you can think of. In fact, Deutsche Bank was recognized by the Euromoney FX market survey as the overall forex market leader by market share in 2022. This market share stood at 10.98%.
Commercial banks (and investment banks) take on a ridiculous amount of forex transactions each day for both their customers and themselves. And based on the supply and demand for foreign currencies, these banking giants determine the bid/ask, spread & exchange rates that we all love (and hate).
Based on the supply and demand for foreign currencies, it is these bank giants that determine the bid/ask, spread & exchange rates that we all love (and hate). Beyond that, it is a known fact that central banks also participate in the free Foreign Exchange market to control the exchange rates of their own currency and have a huge impact on different exchange rate movements.
For example, the US Federal Reserve central bank is involved in stabilizing the US currency and the interest rate parity of the US exchange rate.
2. Central Banks
In addition to commercial banks, central banks also participate in the free foreign Exchange market. They control the exchange rates of their local currencies. They have a significant impact on different exchange rate movements. And without them, there would be no currencies to trade because they control the money supply in their countries. It is in the power of central banks to prevent any financial crisis in their countries through their fiscal and monetary policies. And as you might expect, they have a strong pull on the global forex market.
For example, the US Federal Reserve is the central bank that stabilizes the US dollar and its interest rates. All of these activities by the FedReserve affect everything that happens to the US dollar and how much it’s worth compared to other currencies in the FX market.
3. Investment Managers and Hedge Funds
These people trade the forex market on behalf of individuals, foundations, and establishments with large account balances and investment portfolios. And because of the large investment funds they deal with, they often exert significant pressure on the market.
Hedge fund managers rely on the foreign exchange market to hedge against the risk of exchange rate fluctuations that may otherwise affect the companies they represent. The activities of hedge fund managers in the FX market are significant because of the large hedge funds they handle.
4. Corporations
Multinational Corporations (MNCs) are also a major participant. An MNC has branches spread across various countries, but have their headquarters in one country. They also generate a minimum of 25% of their revenue from the branches outside their headquarters. To move money around within these branches, they often have to get involved in a lot of forex transactions.
Corporations and financial institutions are also major players in the forex market. These corporations mostly participate in the foreign exchange market to do business and trade different currencies as speculative transactions.
For example, if a large US company (say Ford) is buying exclusive car parts from a different country (say Japan), they must exchange currencies, which, in this case, is US dollars for Japanese Yen when purchasing the parts. And that’s how they participate in the forex market.
5. Retail Traders
Individual retail forex traders are the smallest fish in the Forex market, representing just 5.5% of all foreign exchange transactions in 2016. But make no mistake.
Retail traders can buy and sell the same foreign currency pairs as other participants in the global Foreign exchange market. However, they have to go through a longer transaction chain to get hold of liquidity. As such, they usually don’t receive the same transaction costs as participants further up the hierarchy.
Retail traders are also unable to affect the forex markets with their trades because they are far too small to make any waves. Their role is to react to what is going on in the wider market and to position themselves accordingly.
Other Market Participants
Other participants in the forex market include governments, forex brokers, market makers, regulators, and exchange-traded funds.All of these players, in one way or the other, play relatively significant roles in the forex market. Governments invest in the foreign exchange market, for instance, to hedge their own currency against risks of fluctuations in a currency’s exchange rate when compared to a foreign currency. Especially if that market price fluctuation might negatively affect them. Of course, they do most of these through their central banks.
A forex broker makes forex trading possible for individual forex traders through online trading platforms. Some of them are STP brokers, ECN brokers, or market makers. However, they also make trades of their own in the forex market.
KEY TAKEAWAYS
- The forex market has many categories of players who participate in it.
- Retail traders like you and I are only a small percentage of these participants.
- Major banks are the biggest players by market share in the forex market
- Other participants include hedge funds, investment managers, corporations, etc.
Final words
TSo, now you know who the market participants are in the forex market. As you can see, the forex market is complex and is used in various forms, including global electronic trading. This is why it has become so accessible in recent years for any trader who wishes to trade currencies like the Swiss franc, the New Zealand Dollar, the Australian Dollar, the Canadian Dollar, the British Pound, the Euro, and many more.
But let’s not get ahead of ourselves. Next up, what are currency pairs in forex trading?
What are Currency Pairs in Forex?
5 mins read ● Last Updated: 24 October 2023Written by || Shain Vernier
The forex market revolves around what we call currency pairs. They’re the instruments we trade in the market, like the items you buy or sell at the market.
So, what are currency pairs?
What is a Currency Pair?
A currency pair in forex trading is a pair of two national currencies whose values are compared together. With this pairing, you can immediately tell how much a currency is worth in another currency. Often, they are separated by a “/”. But they still mean the same thing if the slash isn’t there.
A perfect example of a currency pair is the GBP/USD.
If you’re confused, don’t worry. Let’s take them one at a time.
What’s a Base Currency?
When you see a pair, the currency that comes first is the base currency. It is the currency that the other currency in the pair is valued against. It’s the one that’s bought or sold for the quote currency.
In the example above, the GBP is the base currency.
What’s a Quote Currency?
This is the second currency that appears in the currency pair and is also known as the ‘counter currency.’ In the example above, the USD is the quote currency.
How Currency Pairs Work
Now that you know the base and quote currencies, let’s tie them together. And to do that, this is the question that every currency pair asks?
“How much of the quote currency do you need to buy the base currency?” So, if you see the GBP/USD pair, you ask yourself, “How much USD (the quote currency) do I need to buy one GBP (the base currency)?
And often, you don’t have to wait too long to get your answer. You’ll often see some prices in front of these currency pairs. These prices are your answer. They’re how much a quote currency will take to buy one piece of the base currency.
So, when GBP/USD has a price of 1.2205, it means it’ll take 1.2205 USD to buy one GBP. Get it?
Types of Currency Pairs in the Forex Market
There are three categories of currency pairs to trade in the Foreign Exchange market:
- Major currency pairs
- Minor currency pairs
- And exotic pairs.
Let’s see what each category means for forex traders.
Major Currency Pairs
Major currency pairs are those pairs that involve the US dollar and any other major currency. Apart from the USD, the other seven major currencies are:
- British Pound (GBP)
- The Euro (EUR)
- The Japanese Yen (JPY)
- The Canadian Dollar (CAD)
- The Swiss franc (CHF)
- The Australian Dollar (AUD)
- And the New Zealand Dollar (NZD)
So, your major currency pairs would be:
- EUR/USD
- USD/JPY
- GBP/USD
- USD/CHF
- USD/CAD
- AUD/USD
- NZD/USD
These major pairs make up 61.5% of the entire trading volume in the Forex market. They even have their own nicknames. Check them out below!
Of all these major pairs, the EURUSD is the most widely traded currency pair.
The Crosses or The Minors Currency Pairs
Currency pairs that do NOT include the U.S. dollar (USD) in their pairing are known as cross-currency pairs or simply as crosses. They’re the pairings of the major currencies with one another.
Euro Crosses:
Fun fact: Back in the old days, if someone wanted to change currencies, they would first have to convert their currencies into U.S. dollars, and only then could they convert their dollars into the currency they desired.
Exotic Forex Currency Pairs
Exotic… you’re probably thinking of exotic countries and exotic belly dancers, but let me stop your imagination there. The label has nothing to do with the location or size of the country (or the number of belly dancers) where the currency is used.
Exotic currency pairs in currency trading are made up of one major currency paired with the currency of an emerging economy, such as Brazil, Mexico, Chile, Turkey, or Hungary. Other currency pairs include EUR/TRY, AUD/NOK, GBP/SEK, and many more.
A benefit to trading exotic currency pairs is that they may offer higher potential returns due to wide price fluctuations. However, this means that trading an exotic currency pair is usually riskier as it has high market volatility and in some cases, heavy involvement from central banks.
The chart below contains a few examples of Exotic forex pairs..
Fun fact: Back in the old days, if someone wanted to change currencies, they would first have to convert their currencies into U.S. dollars, and only then could they convert their dollars into the currency they desired.
Long vs Short Positions in Forex Trading
When trading currency pairs, you’re buying and selling one currency versus the other. As such, if you want to buy a currency (which means buy the base currency and sell the quoted currency), you want the base currency to rise in value and then you would sell it back at a higher price. In other words, you want the value of the Pound to rise against the Dollar.
Let’s assume you have the GBPUSD pair in front of you. Going long on this pair (or buying) means you’re expecting the value of the Pound to rise against the Dollar.
Remember: short = sell.
Unlike most financial markets like the stock market, this is the beauty of the Foreign exchange market. You can easily trade foreign exchange currency pairs in both directions, meaning taking long and short positions. There are no strict margin requirements from your forex broker, and there are more trading opportunities than in other markets. Furthermore, most forex brokers allow you to start buying and selling currency pairs with low initial investment and with the broker’s leverage.
KEY TAKEAWAYS
- Currency pairs compare the value of a country’s currency against another.
- It comprises two currencies: a base and a quote currency. The first currency of the pair is called base currency and the second currency is the quote currency.
- The three categories of currency pairs are major, minor, and exotic.
- Of these categories, major currency pairs boast the most abundant trading volume, and exotic pairs are the riskiest to trade.
- When you buy a currency pair, you’re expecting the price of the second currency to rise against the first listed currency. And when you sell, you’re hoping the price of the quote currency falls against the base currency.
What Are Pips in Forex?
4 mins read ● Last Updated: 23 October 2023
Written by || Nick Quinn
In the last lesson, we learned that we can buy and sell currency pairs, hoping that their prices rise or fall. But how do we measure how much a pair has risen or fallen?
That’s where pips come in.
What is a Pip in Forex Trading?
Just like a pip is the smallest part of a fruit, a pip in the Forex market refers
to the smallest unit by which the price of a currency pair can change. Pip is an abbreviation for
Percentage in Point or price interest point. And it’s the unit of measurement used to express the
change in value in a particular currency pair.
Professional Forex traders express their gains and losses in the number of pips their position rises or falls.
For example, if the EUR/USD moves from 1.2713 to 1.2714, that 0.0001 pip change rise in the exchange rate is 1 pip.
Fun fact: All major currency pairs go to the fourth decimal place to quantify a pip.
A notable exception, though, is the Japanese Yen, which only goes to two.
That second figure after the decimal point in Japanese yen pairs are where we
count our pip value.
Calculating the Value of a Pip
So now that we know what a pip is, what does it mean to us in terms of how much profit we make or how much money we can lose for each price movement?
This depends on the size of the position we open in the Foreign Exchange market. Larger positions mean each pip movement in the pair will have a greater monetary consequence to our balance.
To calculate this is quite simple. Let’s take an example and stick with our two currencies – the EUR versus USD.
Example: One Pip Move
Say we wanted to open a position size of 10,000 units. Our calculation to establish what a one pip movement means to us is as follows:
10,000 (units) x 0.0001 (one pip) = $ 1 per pip
So a position of 10,000 means that every time the pair moves 0.0001 (or 1 pip), we make
a profit or loss of $1.00 depending on which way it moves, meaning the pips value is $1.
If the position moves 100 pips, we will make a profit or loss of $100.
What is a Pipette/Point?
Some forex brokers represent their currency pairs to five or three decimal places
instead of the standard four and two decimal places. That’s because they’re
representing their prices using fractional pips, which are called pipettes or points.
A pipette is a tenth of one pip. Brokers use the so that they can offer their traders tighter spreads.
How Do Pips Work in Forex Trading?
We can do this for currency trades of any size. The calculation is simply the forex trade size x 0.0001 (1 pip).
5,000 (units) x 0.0001 (1 pip) = $ 0.50 per pip
50,000 (units) x 0.0001 (1 pip) = $ 5 per pip
125,000 (units) x 0.0001 (1 pip) = $ 12.50 per pip
The pip value in any currency pair’s exchange rate is always measured in the currency of the quoted currency of the pair, e.g. the quote currency on the right-hand side of the pair.
So in the example of the EUR/USD, we see our pip value is always in US Dollars (which is the counter currency).
If we were trading the USD/EUR pair, the pip value would be calculated in Pound Sterling (EUR being the counter currency and USD being the base currency).
So…
10,000 units x 0.0001 (1 pip) = £ 1.00 per pip
50,000 units x 0.0001 (1 pip) = £ 5.00 per pip
125,000 units x 0.0001 (1 pip) = £ 12.50 per pip
Example: 10 Pip Move
If the value of the Euro increases against the dollar by 10 pips then we would see a movie like this.
10,000 units x 0.0010 (10 pip) = £ 10.00 per pip
50,000 units x 0.0010 (10 pip) = £ 50.00 per pip
125,000 units x 0.0010 (10 pip) = £ 125.00 per pip
Example: 100 Pip Move
If the value of the GBP rises against the dollar by 100 pips then we would see a move like this.
10,000 units x 0.0100 (100 pip) = £ 100.00 per 100 pips
50,000 units x 0.0100 (100 pip) = £ 500.00 per 100 pips
125,000 units x 0.0100 (100 pip) = £ 1,250.00 per 100 pips
KEY TAKEAWAYS
- A pip is the smallest unit by which the price of a currency pair can change.
- It’s basically the fourth decimal number on most forex currency pairs and the second decimal figure on the JPY pairs
- The value of your pip depends on the amount of position you’re investing in a trade.
- A point or pipette is a fractional pip. It’s the tenth if pip. Most brokers have it as a fifth decimal place on most pairs and the third decimal place on the JPY pairs.
Wrapping Up
And that’s all about how a pip works!
Even though you’re now a pip legend, I know exactly what you’re thinking….
Do I really need to calculate all this every time I make a trade?
I know I said to read this and scream at your monitors until you understand it, but I
think now’s the right time to admit that there is an easier way…
Nearly all Forex brokers will work all this out for you automatically on their trading
platforms when you trade forex (…and hey now you know how they calculate it!). Or
you can always use our Pip Value Calculator to know what the pip values are and
analyze price movements in currency trading.
nd on to the next topic where we’ll be talking about what lots are. Here’s a spoiler: See
those units that we multiplied our decimal places by when calculating pip values?
They’re called lots.
What is a Lot in Forex?
4 mins read ● Last Updated: 27 October 2023
Written by || Nick Quinn
The forex market is designed to fit any trader, regardless of their pocket size. To achieve this, every trade you take is measured specific amounts called lots. The bigger your trading account, the bigger the lot size you can trade.
Let’s help you make more sense of forex lots in the rest of this piece.
What are Lots in Forex Trading?
A lot in forex trading refers to the units with which forex trades are measured. It’s the
amount of base currency (in units) you’re buying or selling. With this measurement,
different traders of different pocket sizes can make trades commensurate with their
trading account sizes.
A relatable way to see this is to imagine you wanted to buy pizza. Pizzas come
in different sizes and prices. And the bigger the size you go for, the more pizzas you
have to share with your friends.
In the same way, the bigger your lot size, the more money you must invest. But in
the same vein, the more profit (or loss) you can make.
Why Lot Sizes Matter in Forex Trading
The biggest reason lot sizes are important is because they help you with your
risk management. Depending on your lot size, every pip has a value. So, trades with
larger lot sizes mean each pip costs more than trades with smaller ones.
With the proper lot sizes, you can take a position size that is commensurate with your
account. Otherwise, you may enter positions that are too big for your account,
which could lead to losing money rapidly. Conversely, you may enter positions too
small for your account, making your profits insignificant.
Types of Lot Sizes
There are typically four different lot sizes you will come across when trading forex. They are:
- Standard lot
- Mini lot
- Micro lot
- And nano lot.
Each lot size requires a different minimum investment to open a trade. Each also
has a specific value for every pip movement.
As you can see in the image below, a standard lot size, which is the maximum possible
contract size provided by online forex brokers, is a forex trade of 100,000 units of the
base currency. Hence, in this case, when you trade forex standard lot size, the pip value
of a standard lot size is $10 per pip.
The mini, micro, and nano lot sizes are smaller lot sizes that enable traders to open
smaller positions and to be able to trade the forex markets with lower invested capital.
What is a Standard Lot?
The standard lot size is what you will see most regularly when trading with the standard
account types of many forex brokers. A standard lot is a 100,000-unit lot of the base
currency, and trading with this trade size means that each pip movement in your trade
would be worth $10.
In forex, one standard lot refers to the volume of 100,000 currency units. So when you
buy one lot of a forex currency pair, you purchase 100,000 units from the base
currency.
Let’s say you want to buy Euro versus the US dollar on a standard lot size, and the
EURUSD exchange rate is 1.17. You will be making $117,000 worth of purchase.
Standard lots are perfect for traders who have huge capital to trade with. It’s also great for long-term traders.
What’s a Mini Lot?
In Forex, one mini lot refers to the volume of 10,000 units, which is one tenth the size of a
standard lot. So when you buy one mini lot of a forex currency pair, you purchase 10,000
units of the base currency.
For example, you want to buy EUR/USD at a mini lot size at an exchange rate of 1.17. You
will be making $11,700 worth of purchase.
A mini lot size is a great choice for those who may want to trade forex with slightly lower
capital. But don’t let the name fool you! Even though they are referred to as mini lots,
they still represent a very significant investment (and can generate a significant
profit/loss).
Mini lot sizes are perfect for traders who want a mix of different trading styles. This is
because mini lots allow more flexibility than standard lots but without as much risk.
What’s a Micro Lot?
Micro lots are among the smallest tradable lot sizes in the forex market. They provide a
safe platform for beginner traders to get good value for money and a taste of the
industry with a low initial investment while keeping the risk to a minimum.
A Micro lot equals 1% of the standard lot (100,000 x 0.01 = 1.000 units). If your account is
funded in U.S. dollars, this means that a micro lot is $1,000 worth of the base currency
you want to trade, and each pip value would be worth just 10 cents.
In Forex, one micro lot refers to the volume of 1,000 units. So when you buy one micro lot
of a Forex currency pair, you purchase 1,000 units from the base currency.
Once again, assume you want to buy EUR/USD on a micro lot at an exchange rate of 1.17.
You will be making $1,170 worth of purchase.
What’s a Nano Lot?
A nano lot is the smallest trading lot size available in a trading account. It offers real
money trading beyond a demo account, and with a much smaller level of risk involved
when compared to lot sizes.
In Forex, one nano lot refers to the volume of 100 units. So when you buy one nano lot of
a forex pair, you purchase 100 units from the base currency.
Assume you want to buy EUR/USD on a nano lot size and at an exchange rate of 1.17.
You will be making $117 worth of purchase.
For many traders who want to make the first step into the trading arena, nano lots are
the ideal lot size to start trading as you still get the sense of the forex and financial
markets, and at the same time, there’s no high risk of losing a large sum of money.
Which Lot Size Is Best For Trading A Currency Pair?
The forex lot size that works well for you depends on several different factors based on
how you want to trade forex. Some of these factors include:
- Risk tolerance: If you’re comfortable taking huge risks, you can for a standard lot
size. But if you’re still testing the forex waters and would rather tread carefully, micro
and nano lots may suit you best. - Trading platform: Some trading platforms can limit the lot sizes you’ll have access
to, depending on your account size. Some will restrict you to nano lots if you don’t
have enough capital. Others would allow you to go crazy on the standard lot size if
you have a sizeable account balance. - Market conditions: Sometimes, the market is not moving with as
much volatility as you would like. In these times, you want to increase your lot sizes so that minimal
price movements can still offer you sizeable profit. And in situations where the
market is very volatile, you want to reduce your lot sizes to avoid taking on too
much risk. - Trading strategy: Some trading strategies require that you use bigger lot sizes. If
you’re a day trader, opening and closing trades within a single trading day,
you may want to reduce your risk exposure per trade by using smaller lot sizes.
Our investment advice is to have at least $100,000 of trading capital in your account
balance before opening a standard trading account. Use $10,000 for a mini account
and $1,000 for a micro account.
But remember, even small movements in the price of currency pairs could send you to
the point of no return with the wrong lot size.
KEY TAKEAWAYS
- A forex lot refers to the unit with which forex trades are measured. This
measurement allows traders to take trades that are commensurate with their
account equity. - There are four forex lot sizes; standard size, mini, micro, and nano.
- A standard lot size is best for traders with large accounts while a nano lot size just
works for traders who want to test the forex markets without putting it too much
money.
Bid, Ask and Spread in Forex Trading
4 mins read ● Last Updated: 11 December 2023
Written by || Shain Vernier
So far, we’ve described currency pairs as having just one price or exchange rate. But
this is not entirely true. If you’ve ever used an online broker or a trading platform, you’ll
notice that there are usually two sets of exchange rates or prices in front of a currency
pair. Those two prices are called bid and ask prices, and the difference between them is
called spread.
The rest of this lesson will shed more light on them, including how they influence your
trading.
Understanding the Concept of Buying and Selling in Forex
Buying and selling in the foreign exchange market is not as straightforward as you may
think. The number one reason for this complication is that in forex, we trade currency
pairs, not single currencies.
The second source of complication is that in forex, we never really get to own any of
the currencies in the pair we’re buying or selling.
For instance, when you buy GBPUSD, no one transfers Pound Sterling or Dollars to your
bank account. You also don’t need to own either before entering a short position on the
GBPUSD.
Because of these complications, it can be tricky to pinpoint what we’re selling or buying,
what it means to buy or sell, and at what price we’re carrying out our transaction.
So, to help you understand what’s going on, you first need to know what an exchange rate is:
What are Exchange Rates in the Forex Market?
The exchange rate of a currency pair in forex is simply the amount of the quoted
currency required to buy one unit of the base currency.
The example below shows the British Pound exchange rate versus the US dollar.
When buying, the exchange rate tells you how much you have to pay in units of the
quoted currency to buy 1 unit of the base currency. In the example above, you must
pay $1.27223 to buy £1. When selling, the exchange rate tells you how many units of the
quoted currency you get for selling 1 unit of the base currency. In the example above,
you will receive $1.27223 when you sell £1.
Exchange rates vary based on supply and demand, which is usually determined by
interest rates and the central bank monetary policies of participating countries.
Next, what does it actually mean to buy?
What it Means to Buy in Forex
When you buy a currency pair in forex, you won’t own that currency pair. What you’re
doing, though, is that you’re speculating that the exchange rate of that pair will rise,
and you’re betting your money on it. If the price eventually rises, your broker pays you the
difference between your buying price and the price when you opt out of the trade.
Let’s continue with our GBPUSD example from above. The exchange rate is 1.27223, and
you buy. This means you speculate that the exchange rate of GBPUSD will increase. By
clicking the “buy” button on your trading platform, you’re initiating a contract with your
broker that allows you to profit or lose money from the price difference between the
price you’ve bought at and a future price.
If the price rises to 1.27225 after a while, the difference would be three pips. So, if you
traded on a standard lot size, you would gain $30 because a standard lot pip value in
GBPUSD is $10. If the price falls instead by the same difference, you pay the broker that
amount.
So, you see, you won’t own GBP or USD when you buy in forex. Instead, you’re
speculating that the price will rise.
What it Means to Sell in Forex
You don’t need to own any of the currencies in a forex currency pair before you can sell
it. Instead, you’re speculating that the currency pair’s exchange rate will fall, and you’re
betting your money on it.
If the price falls to a lower price, your broker pays you the difference between your
selling price and the price when you opt out of the trade.
Returning to our GBPUSD example. Clicking on the “sell” button means you think
the price will fall. If it falls to 1.27220 from 1.27223, your broker calculates how much
the difference of three pips translates to on your position size and pays it to you. But if the
price rises to a higher price, you pay the difference.
Bid, Ask, and Spread in Forex Trading
Now that you understand what buying and selling truly mean in the forex market let’s
delve into the bid and ask prices.
What is Bid Price?
The bid represents the price at which you can SELL a currency pair. It’s the one that
comes first on the price quote on trading platforms.
Imagine you were trying to sell your old monitor to a shop that buys used ones. (Now
that you’re a trader, you’ll need a new, bigger one!). To make a profit, the shop will need
to buy your monitor at a price lower than the price they’ll sell it for.
If the store can sell the monitor for $600 and it most likely wants to make any money,
the most it can buy from you is $599. In this situation, $599 is the bid price.
Let’s bring it back to Forex. In the quote GBP/USD 1.8812/1.8815, the bid price is 1.8812.
This means you sell £1 for $1.8812. And when you execute your sell trade, this is your selling
price.
What is Ask Price?
The ask is the market price in a trade at which you can BUY the currency pair from your broker.
Going back to our monitor imagination, imagine you didn’t have an old monitor to swap
in the first place. You want to buy your first yet. The shop will sell it for you at a price
higher than what they bought it for. If they bought it for $590, they would sell it for $600.
This $600 is the asking price.
Returning to forex, in the quote EUR/USD 1.2812/1.2815, the ask price is 1.2815. This means
you can buy €1 for $1.2815.
Typically, the ask rate will always be higher than the bid rate.
What is the Spread in the Retail Forex Market?
Spread is the difference between the bid and ask price. Some others call them bid-ask
spreads. It is one of the ways a broker makes their money.
Generally, forex spreads are crucial in forex trading and selecting a good forex broker
because they differ from one forex broker to another. When you enter a forex trade,
you essentially start the trade with a loss because there’s a bid-ask spread between the
two currencies. In most cases, this price difference is basically what you pay
your broker, and only if the market moves in your direction (to cover the cost of spread) will
you see a profit in your trade.
Let’s take the GBPUSD quote of 1.8812/1.8815 as our example again. The spread here is 3
pips, the difference between the bid price and the ask price. As soon as you initiate any
foreign exchange transaction with your broker, your trade starts out at negative 3 pips
(-3 pips).
Another factor to consider is that a forex spread varies depending on the instrument
you are trading and its liquidity. Wide spreads are more common in foreign currencies
that have low liquidity (minor and exotic currency pairs). And when a particular
currency pair has a tight spread, it is a very volatile pair. Popular examples are EUR/USD,
USD/JPY, and AUD/USD. For that reason, many forex traders choose to trade major
currency pairs to avoid a wider spread and to be able to get in and out of positions
quickly.
Types of Spread
Forex brokers offer two types of forex spreads:
- Variable Spread: Variable forex spreads fluctuate when market conditions change.
- Fixed Spread: Fixed spreads always stay constant, regardless of the
market condition
Most often, traders who trade frequently within a short period will find variable spreads
more beneficial. On the other hand, long-term traders wouldn’t care so much about
having their spread variable or fixed.
Key Takeaways
- An exchange rate is the amount of the quoted currency you would need to buy
one unit of the base currency. - You don’t actually have to own any of the currencies in a pair before you can buy
or sell them in forex. You’re only speculating about their price movements, not
buying and selling the actual currencies. - We sell at the bid price, while the price we buy at is the ask price.
- The difference between the ask and bid prices is your spread. This spread is the
primary method of earning for brokers.
A spread in the foreign exchange market is the primary transaction cost when you are
involved in any forex trade. Therefore, it is not a surprise that you need to understand
what they are, as they can significantly impact how you trade the markets.
How Does Forex Leverage Work?
4 mins read ● Last Updated: 3 November 2023
Written by || NickQuinn
There used to be a time when only the rich could trade forex because the capital
requirement was huge. The minimum was $50,000. But not many retail traders had this
much money lying around then. Not even now.
And this is where leverage comes into play. It’s the market makers’ way of making the
forex market open to everyone with minimal trading capital.
In this lesson, we’ll describe leverage and everything you need to know about it. We’ll
also show you how leverage, despite the massive edge it gives the trader, can also be
the end of the trader.
What is Leverage in Forex?
In Foreign Exchange markets and financial markets in general, leveraged trading is
defined as using borrowed money from a forex broker to increase earning potential.
Simply put, leverage trading (also known as margin trading) is essentially borrowed
money provided by a Forex broker to get involved in potentially high-profit trades in the
forex market without having to invest vast swathes of your own capital.
When you use $50,000 for a $50,000 investment, this is called 1:1 leverage or no
leverage. Unfortunately, not many forex traders have $50,000 to trade with. But
fortunately, forex trading is not leveraged 1:1. You’re leveraged anywhere from 3:1 all the
way up to a forex leverage ratio of 1000:1.
Fun fact: Forex trading was traditionally reserved for society’s elite who could
afford to come up with large amounts of capital and required a high initial
investment. Traditionally, $50,000 had to be invested as a starting trading
capital.
How Does Leverage Work in Forex Trading
Let’s take 100:1 leverage as an example. A forex leverage ratio of 100:1 means you can
trade a notional value 100 times greater than the capital in your trading account. So
now, you simply have more money in your trading account to leverage your currency
trading.
To control a $50,000 position size, for instance, your forex broker will set aside $500 from
your account and lend you the remaining $49,500. So, if your $50,000 trade makes a
profit of 1%, you have $500. And just like that, you get a 100% profit on your own $500.
Sweet, eh?
But with great power comes great responsibility. If you lose $500 instead on the $50,000
trade, that’s all of your $500 investment gone. And that’s why they say leverage is a
double-edged sword.
Let’s take the GBP/USD currency pair with a quote of 1.2700/12703 as an example. From
the last lesson about forex ask-bid spread, you know that the bid price is 1.2700, and the
ask price is 1.2703.
Without leverage in forex trading, opening a one lot size sell trade (100,000 units) would
require a trader to invest around $127,000. Using a leverage level of 500:1, we can
dramatically reduce the capital needed. We can use a simple formula to calculate
leverage and work out the amount of invested capital needed:
You only need $254 instead of the $127,000 it would have originally cost you.
Keep in mind, however, that although leverage is mainly associated with forex trading,
many online brokers also enable traders to use leverage when trading CFDs. This means
that not only you can use leverage when trading the forex markets but also
when trading CFDs such as commodities, stocks, indices, ETFs, and cryptocurrencies.
The maximum leverage ratios vary depending on the market and instrument traded.
Usually, traders can adjust the leverage level directly on the broker’s trading platform.
How Do Forex Traders Use Leverage?
In addition to knowing how leverage works in forex, it is also essential to know when to use it.
First, Don’t get fooled by the favorite selling point of many forex brokers – high leverage
ratios. Yes, you can make a huge killing using tremendous leverage in forex trading, and
it certainly increases your potential profits in the Foreign Exchange market. But, you
should also know that you could easily be killed by enormous leverage provided by
forex brokers as well. In the words of many forex traders and professional traders-
leverage is a double-edged sword.
What do we mean by that?
When leverage works in forex trading, it significantly magnifies your profits. Your head
gets BIG, and you think you’re the greatest forex trader ever. But there’s a catch. But
when you trade forex, leverage can also work against you. If your trade moves in the
opposite direction, leverage will amplify your losses, causing you to lose money rapidly.
Here’s a chart of how much your account balance changes if prices move
depending on your leverage.
Our advice? When you make your first steps in the forex market, be realistic in
your expectations, and don’t start forex trading with real money and the maximum l
everage your forex broker provides. Many forex traders set a relatively low optimal
leverage ratio to control their brokerage account and reduce the high risk of trading
with high forex leverage ratios.
Play it safe. Protect your capital. And even if you decide to use a low leverage ratio,
you must ensure you use key risk management tools and be alert to a margin call on your
trading platform.
KEY TAKEAWAYS
- Leverage is the use of borrowed money from a forex broker to increase earning
potential. - If a broker offers leverage of 1:500, it will provide you with 500 times your capital to
trade with. - Leverage can help increase your earning potential, but also cause you to lose just
as much.
What is Margin in Forex?
5 mins read ● Last Updated: 11 December 2023
Written by || Nick Quinn
As discussed in the previous lesson, when trading Forex, you only need to put down a small amount of capital, also known as the margin, to open a new position. This type of trading is known as margin trading and is one of the key reasons many traders are drawn explicitly to trading the forex market.
In this lesson, we’ll show you how margin works in forex and how to use leveraged trading in the forex markets effectively.
What is Margin in Forex Trading?
In simple terms, margin is a percentage of your funds that your brokerage firm sets aside to ensure that you can cover the potential loss of the trade. See it as collateral or a “good faith deposit.” Should you lose the trade, the broker takes it from you.
For example, if you want to buy $100,000 worth of USD/JPY, you don’t need to invest the full value. Instead, you only need to deposit a portion of the margin required by your forex broker (depending on your Forex broker and leverage). On a leverage of 1:20, for instance, your margin would be $5000.
This portion is ‘locked up’ by your broker for the duration of the specific trade. Once the trade closes in a positive, the margin is released back into your trading account, and you can now use it again to open a new trade. This is, in a nutshell, how margin is used in the Foreign Exchange market.
Margin and leverage are inversely tied to each other. This means 2% margin translates to 1:50 maximum leverage. Also, 5% margin is 1:20 leverage.
Finally, Margin is not a transaction cost or a fee. It is simply the amount your broker keeps away from your entire account balance to keep your trade open.
What Is A Margin Requirement In Forex Trading?
Margin is usually expressed as a percentage of the full amount of the position. For example, most Forex brokers say they require 0.25%, 0.5%, 1%, 2%, 10%, or 25% margin. And when you trade forex, this percentage is known as the Margin Requirement.
Here are some examples of forex margin requirements for different currency pairs:
As you can see above, the forex margin requirement for the EUR/USD is just 2%, which means the broker provides a leverage ratio of 50:1. So, if you wanted to open a trade with a mini lot size, the nominal trade size is $10,000. But with a 2% margin, you only need to supply $200. It also means you can only have 50 open positions of that size at one time. This margin is called your initial margin.
For that matter, some forex brokers provide even a higher leverage ratio of up to 500:1 and even 1000:1. With that said, these ratios also significantly increase the risks involved in trading currency pairs and trading CFDs.
How To Calculate The Required Margin In Forex Trading?
If the base currency is the same as your account’s currency, this is the formula to calculate forex margin:
Required Margin = Notional Value x Margin Requirement
A perfect example is if you wanted to buy the USDJPY currency pair on a mini lot and you have $1000 in your forex trading account. This means you want to buy $10,000 worth of the position.
If your broker has a margin requirement of 5%, your required margin, according to that formula, would be $500.
However, if the base currency differs from your account’s currency:
Required Margin = Notional Value x Margin Requirement x Exchange Rate Between Base Currency and Account Currency.
For instance, assume you still have $1000 in your forex trading account, and you want to buy GBPUSD at 1.2700 on one micro lot. That means you’re buying 1000 units worth of position. On a margin requirement of 3%, your required margin, according to our formula, would be $38.1.
That means you only need $38.1 to open that trade.
You don’t have to calculate your margin manually. Your broker does that for you. You can also use a third-party forex margin calculator.
What is Free Margin in Forex Trading?
Forex free margin is the amount of margin left on your account that you can open new trades with. If you have a trade open, your free margin can rise or fall depending on the ongoing outcome of the trade. It’s gotten by subtracting your required margin from your account equity.
By the way, your account equity is the sum of your account balance and your unrealized profit or loss from your open positions.
Let’s take the USDJPY trade you had open from up there as an example. At the moment of opening the trade, this is what your forex account would be like.
Account Balance = $1000
Margin Required = $500 (5% of your $10,000 position)
Account Equity = $1000
Free Margin = $500 (The difference between account equity and margin in use)
But assume the position goes a few pips in your direction, and you’re in $100 profit. This is what your account would look like:
Account Balance = $1000
Margin Required = $500 (5% of your $10,000 position)
Account Equity = $1100
Free Margin = $600 (The difference between account equity and margin in use)
This means with your trade in profit, you can still open more forex trades using your $600 free margin even without first closing the currently opened trade.
The next thing you need to know is margin level.
What is Margin Level in Forex
Margin level is your forex broker’s way of telling you if you can still open trades based on what’s left in your account.
The formula for calculating your margin level in forex is given by:
When you have a margin level of 0% when you have no trades open. Typically, you want to keep your margin level as far away from 100% as possible. The farther away you are from 100%, the more trades you can open. Some brokers set their margin level limits at 100% so your trades are automatically closed when your margin level hits that level.
Let’s continue with our USDJPY example to illustrate your margin level. When you’re in $100 profit, your margin level, according to our formula, would be 220%. This is far enough away from 100%, so the account is very healthy. You can still open further trades.
But when the trade starts going against you, and your margin level falls to your broker’s limit, your open trades are closed. Before this happens, though, the broker notifies you that your margin is getting close to or below the margin level threshold. Such notifications are called a margin calls in forex trading.
KEY TAKEAWAYS
- Margin is the minimum amount a forex trader must have to open a trade on their forex account. It’s the security deposit your broker takes to open a trade.
- The margin varies depending on the margin requirement of the broker and the position size you’re attempting to trade.
- Your account equity is the sum of your trading account balance and the profit or loss of your currently running trade(s)
- Free margin is the difference between hour account equity and the used margin.
- Margin level is the percentage of the ratio of your account equity to your free margin. The farther your margin level is from 100%, the more positions you can still open.
Conclusion
At this point, we believe you know everything you need to know before you begin trading on margin. Don’t forget that it is still possible to lose more than your initial deposit in a trade. To avoid this, you need to learn how to manage your trade like a pro.
Why Trade Forex: Forex vs Stock Market
4 mins read ● Last Updated: 11 December 2023
Written by || Nick-Quinn
Stock market trading and Forex Trading are both viable paths to financial success. Still,
before you start trading Forex or you trade Stocks, it is important to find out which is
best suited for your trading strategy, your trading style, and your risk appetite.
Deciding which financial markets to trade does not have to be complicated, and many
factors can be considered to make the best choice.
Take a look at our Forex vs. Stocks comparison and explore the key differences between
forex trading and stock trading.
Forex vs Stock Market
Below, you can find six main factors that will help determine which market is best for
you – the foreign exchange market or the stock market.
1. Liquidity
The Foreign Exchange market is the most liquid financial market in the world, with an
average daily trading volume exceeding $7.5 trillion. The Forex market can absorb
trading volume and transaction sizes that dwarf the capacity of any other market. This
high liquidity essentially means you’ll get market execution when trading forex, and
you’ll never get into a situation where you won’t find a buyer or a seller.
Let’s use the stock market for comparison.
All the world’s combined stock markets don’t even come close to the daily trading
volume in the Forex markets. The largest stock market, the New York Stock Exchange,
(only) trades an average daily volume of $22.4 billion.
2. Market Trading Hours
The Forex market never sleeps! The FX market is open 24 hours a day and five days a
week, only closing during the weekend.
This is convenient for those who don’t want to quit their full-time job and dedicate their life
to trading because you can choose when you wish to trade.
The trading sessions for the stock market, on the other hand, are limited to an
exchange’s opening hours. For example, in the U.S., most stock exchanges open at 9:30
AM EST and close at 4:00 PM EST.
3. Simplicity
There are approximately 2,800+ stocks listed on the New York Stock Exchange. Another
3,300+ are listed on the NASDAQ. It can be challenging for even the most seasoned
traders to keep an eye on them all.
You may argue that with the currency market, there are hundreds of currencies to
trade. However, the major ones are only a few, and there are usually a lot of trading
opportunities with these currency pairs.
On the other hand, most forex traders tend to lean into a few major currencies. About 7
of them. And seven major pairs are much easier to watch than thousands of shares,
don’t you think? (Especially when you have the HowToTrade free courses by your side
every step of the way).
4. Capital Required
Getting started as a Forex trader doesn’t necessarily cost a ton of money, especially if
compared to trading stocks or futures.
When trading CFDs, online Forex brokers offer ‘mini’ and ‘micro’ trading accounts, some
with a minimum account deposit of just $25. Also, forex market offers leverage trading
up to 1000:1 sometimes through their brokers. So you can use low initial investment and
take advantage of small market movements.
Now, we are NOT saying you should open a trading account with the bare minimum,
but it does make currency trading much more accessible to individuals who want to
test the waters before diving in too deep!
5. Free Demo Account
Most online Forex brokers offer free demo accounts to practice trading before risking
your hard-earned money. Free demo accounts are valuable resources for all beginner
Forex traders who want to sharpen their trading skills with pretend money and ZERO risk.
Again, this is something stock traders can envy, as demo accounts are unheard of in
the stock market.
6. Market Influences
For both markets, the laws of supply and demand are in full force. However, some factors
affect the demand and supply of these financial markets.
The stock market, for instance, is influenced by the happenings within the company
whose stock you’re trading. Their financial reports, including their revenues, debts,
and other important financial figures, affect where the stock price goes.
For the forex market, though, the forces influencing its demand and supply are much
more complex. We’re talking macroeconomics of the countries involved in the currency
pair you’re trading and not just one economy. The forex market also has participants
like central banks and large commercial banks whose activities can affect the
market’s direction. Other significant players in the forex market are institutional
investors and hedge funds.
Stock Market Trading or Forex Trading?
Both forex and stock markets are great markets for beginner traders to start their
trading journey. These popular global markets provide higher trading volume than
other markets and the ability to make money from future price movements.
Still, like all things in life, you must learn to crawl before you can walk. And Forex or stock
trading is no different.
Forex Basics Quiz – Level 1
4 mins read ● Last Updated: 25 July 2023
Written by || Tom Chen
Let’s see how much you’ve learned from our How To Trade Academy Level 1.
Answer to all the questions from below to receive your Level 1 certificate.