How to Trade Forex

Currencies: Base and Counter

What sets Forex Trading apart from trading in other markets is that with Forex two products are technically being traded at the same time, with one currency being bought whilst the other is sold. This is because the value of one currency is always determined by its relation to another. Forex is always quoted in pairs, for example, EUR/USD (Euro vs, US Dollar), or USD/JPY (US Dollar vs. Japanese Yen). The first value in the currency pair is called the base currency, and the second, the counter currency.

What is leverage and how does it work?

Leverage and Trading Forex

What is leverage and how does it work?

Many speculators find forex trading an attractive option because of the large amount of leverage it offers. Leverage refers to the use of a small quantity of one asset to have an effect over a larger amount of another asset. In forex trading, it takes only a relatively small amount of capital to initiate a significantly larger sized trade. Because of this, a high rate of possible leverage means that the size of your trades are not limited by the capital in your bank account.

Leverage is typically expressed as a ratio. For example, a 50:1 leverage ratio means that for every $1 you have in your account, you can place a trade worth $50. In this particular case, a trader would only need to deposit 2% of the intended trade to proceed with a particular position/ (1/50 = 0.02 = 2%). So theoretically, to trade $100,000 of currency, only a $2,000 deposit would be required.

Alternatively, trading in solid assets would limit a trader by the sum of capital in that currency that he owned. For example, if a trader had £1, they could only trade £1 worth of currency.

When trading forex, each currency pair can have a different leverage scale. For example, the leverage on pairs offered by ETX Capital varies, from 14:1 EUR/HUF (Euro/Hungarian Forint) to 200:1 for pairs such as EUR/USD and GBP/USD (traders should keep in mind that leverage settings are changeable based on market conditions).

However, it is important to be aware of both the benefits and pitfalls of using leverage. When making a profit on leveraged investments, the returns can be large. Nonetheless, the risk of losses can be equally significant if the market moves in the opposite direction to one’s trade. Because of this, increasing the leverage scale increases the risk of a trade, and it takes education and experience to know when to use leverage and to what extent.

Forex trading: Going long and short

As currencies are traded in pairs, when you make a trade you are referred to as “going long” on one currency and “going short” on the other. For example, if you sold one standard lot (equivalent to 100,000 units) of EUR/USD, you would have exchanged Euros for Dollars and would be "short" on Euros and "long" on Dollars.

Put slightly differently, if you purchase a television for $500, you are exchanging your money for that television. You become "short" $500 and "long" one television. This same principle applies to trading currencies in the Forex market.

going long

Going long

A trader suspects that the Euro will strengthen against the Dollar, and decides to ‘buy’, or ‘go long’ on €10,000, at a price of 1.4989, with a leverage scale of 1:50.

Deposit needed = (10,000 x 1.4989/50) = €299.78

To the traders’ fortune, the Euro strengthens against the Dollar. The trader then decides to ‘sell’ €10,000 in order to close the trade, at a price of 1.5076, a rise of 87 percentage points above the opening position.

Profit made: (1.5076-1.4989) x 10,000 = $87

Alternatively, if the Euro weakened against the Dollar – contrary to the traders’ prediction – with the sell price dropping to 1.4902, the trader may decide to ‘sell’ at this point, and close the €10,000 trade.

The trader’s loss would be: (1.4989-1.4902) times 10,000 = -$87

Going Short

Going short

Let’s take the following scenario; after conducting some thorough research, a trader believes that the US Dollar is likely to soon strengthen against the Euro. Consequently, the trader decides to go short on EUR/USD – purchasing Dollars in exchange for Euros. The currency pair is currently trading at bid/ask rate of 1.6764/1.6770. The trader selects the maximum leverage scale of this currency pair, 200:1, and ‘sells’ $10,000 at that rate of 1.6770.

To calculate initial deposit:
Amount of currency to purchase x counter currency exchange rate / leverage scale

That means a payment of $83.85 is required for the initial deposit (10,000 x 1.6770/200). After a short period, the market moves in accordance with the trader’s prediction, and the Dollar strengthens against the Euro.

The bid/ask rate becomes 1.6811/1.6817, and the trader decides to close the position here. The trader ‘buys back’ the €10,000 at a price of 1.6811.

The trader opened at 1.6770 and closed at 1.6811, an increase of 41 percentage points (pips).

To calculate profit:
Profit = (price closed at - price opened at) x amount of currency purchased

So, the trader has earned $41 from this trade [(1.6811-1.6770) x $10,000].

In an alternative scenario, the markets move in the opposite direction to the trader’s position: the Euro strengthens against the Dollar. As a result, the trader decides to ‘buy back’ the €10,000 when the bid/ask rate reaches 1.6720/1.6726.

To calculate a loss:
Profit = (price opened at - price closed at) x amount of currency purchased

In this instance, the trader made a loss of $50 from this trade [(1.6770-1.6720) x $10,000 = $50].

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