How forex trading works?

Going Long or Short

A long position is a situation in which one purchases a currency pair at a certain price and hopes to sell it later at a higher price. This is also referred to as the notion of "buy low, sell high" in other trading markets. In Forex, when one currency in a pair is rising in value, the other currency is declining, and vice versa. If a trader thinks a currency pair will fall he will sell it and hope to buy it back later at a lower price. This is considered a short position, which is the opposite of a long position.

On every exchange, a trader has a long position on one currency of the pair and a short position on the other currency. A trader defines his or her position as an expression of the first currency of the traded pair. The first currency in a pair is known as the base currency. The second currency in the pair is called the counter currency. When a trader buys the base currency he or she takes a long position on a pair, if a trader sells the base currency he or she shorts the pair.

There are few more things you need to learn before your first trade. Let's use an example to understand these essentials.

A trader buys 10,000 EUR with 13,387 USD and closes the position by selling 10,000 EUR for 13,494 USD. The trader makes 107 USD in gross profit (or 0.799% of the initial 13,387 USD investment).

Working Example

Now individuals are unlikely to have 10,000 USD or EUR and even if you do, it is recommended that you don't trade with all of it. So you start with say $200 and borrow the remaining $9,800. This is called "Leverage". One way to leverage your capital is through a Margin Account. The level of margin available in forex can be as high as 1:500 (for every 1 USD or EUR you put, the broker puts in 500). In our example we will work with a 1:50 leverage to trade 10,000 EUR with an initial invest of just 200 EUR.

Margin account is a double edged sword. When you win, you win more because of leverage. But when you lose, you also lose fast. It is therefore necessary to have a full understanding of how margin accounts work. Never risk an amount that you cannot afford. Keep in mind that if the markets drive your positions to a value lower than the one allowed by your margin, some or all of your positions will be closed and you will realize losses. The forex broker automatically does this for you.

Bid, Ask, Spread

A "bid" price is the highest price that a buyer is willing to pay, which is the price you get if you sell something in forex. An "ask" price is the lowest price that a seller is willing to accept, which is the price you get if you buy something in forex. In the previous EUR/USD example, the rate is 1.3382-1.3387. 1.3382 is bid price and 1.3387 is ask price. At this rate, you pay 1.3387 USD to buy 1 Euro and you get 1.3382 USD to sell 1 Euro.

The bid is always lower than ask. The difference between the bid and the ask price is called bid-ask "spread". This is how brokers are compensated. For major currencies, the spread is in general within 0.0005.

Remember long is equal to buy. You buy (which means you buy the base currency and sell the quote currency at the same time) when you expect the base currency to appreciate, so that you can sell it back at a higher price. "Buy low and sell high" is the way to make money here. The previous EUR/USD example is a "buy low and sell high" strategy.

Remember short is equal to sell. You sell (which means you sell the base currency and buy the quote currency at the same time) when you expect the base currency to depreciate, so that you can buy it back at a lower price. "Sell high and buy low" is the way to make money here.

What is a "safe" currency?

In reality there is no safe currency. Every currency is open to price fluctuations and risks. However, arguably there are some currencies that tend to weather bad periods better than others. All major currenies are considered stable and hence in some sense safe. Historically the US dollar was considered “safe” (or safer than others). However, in the recent crisis we have seen it weaken and fluctuate. Some argue that Canadian dollar is becoming a safe currency due to Canada's performance in the crisis. At the end of the day, do your due diligence and follow technical and/or fundamental analysis before taking a trade position.

Lots and Pips

Lots is a standard of measurement in the forex industry. There are two types of lots, the standard one is 100,000 currency units and the mini one, with 10,000. Recently mini-lots have also emerged, but work at higher net transaction fee. The size of the lot normally will be pre-set at the time you open your account, with some forex providers creating mini-forex accounts, funded with as little as 50$. Thanks to leverage you can still participate is large lot sizes.

A Pip is the smallest increment allowed in forex for a currency. Using one unit of a currency, one PIP is 0.0001 - For the US$ a PIP would be 1/100 cents. The only exception is when the Japanese Yen is the currency, where only two decimals are used - The reason is that one japanese cent is worth between 0.0001 US$ and 0.0002 US$.

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