HOW A CURRENCY (FX) TRADE WORKS

• kevinmhughes
• September 24th, 2009

The article is to help traders that are new to the FX Market or don’t understand the FX Market and how things work.  On the face of things, this market seems over some peoples head and they are not willing take the time to understand the inner workings or how it can be beneficial to everyone’s financial strategy.  I hope this sheds some light on things…

1. Reading A Currency Quote
Currencies are quoted in pairs, e.g. GBP/USD, USD/CHF etc. The first listed currency is called the “base” currency. The base currency is the basis for the buy or sell transaction. The second listed currency is called the “cross” currency.

As an example, if you place a buy GBP/USD order with your broker what you have effectively done is sell US dollars and bought Great British pounds (GBP). By definition, the first currency is the stronger between the two.
Let’s look at another example: USD/CAD
If you believe that the Canadian government is going to weaken its currency (Canadian dollar) in order to help its export industry you would BUY USD/CAD (in trading terms: GO LONG). Why? Because you want to own US dollars while they appreciate against the Canadian dollar. On the other hand, if you believe that due to instability in the US economy the US dollar will lose value you would execute a SELL USD/CAD (in trading terms: GO SHORT). By doing so you have sold US dollars with the expectation that they will depreciate against the Canadian dollar.
There are many currency pairs in existence. However, the ones we consider important are those with the best market liquidity, i.e. the most heavily traded. They possess all the quality a good market has for trading purposes.

The following is a list of these currency pairs:
EUR/USD : Euro and United States dollar
USD/JPY: United States dollar and Japanese yen
USD/CHF: United States dollar and Swiss franc
GBP/USD: Great British pound and United States dollar
AUD/USD: Australian dollar and United States dollar
USD/CAD: United States dollar and Canadian dollar

2. Understanding Pips
Every currency pair has a corresponding value and hence a quote. For example, a GBP/USD quote could be 1.6054. This means that the exchange rate for every GBP is USD 1.6054. In other words, it would cost the trader USD 1.6054 to buy a single GBP.  A pip is the smallest price change that a given exchange rate can make. In our example a move from 1.6054 to 1.6055 would indicate a 1 pip increase. Since most major currency pairs (but not all, example of an important exception is the USD/JPY pair) are priced to four decimal places (.0000), the smallest change is obviously that of the last decimal point, or one basis point.

3. Calculating Pip Value
The value of a pip depends on the amount that is being bought or sold of that specific currency.

Let’s use a 10,000 unit purchase for our example. Formula: (one pip with proper decimal placement/currency exchange rate) X (amount being purchased) = pip value

Example: GBP/USD Rate is 1.6054
0.0001/1.6054 X GBP 10,000 = 0.6229 GBP. Since we want the value in USD we multiply the GBP pip value by the exchange rate: 0.6229 X 1.6054 = USD 1.00.  In other words, in a USD 10,000 purchase of GBP’s the pip value is one dollar.

We can see that when the USD is the weaker currency between the two, a pip value will be one USD.  However, this is not the case if the USD is the stronger currency. Let’s look at some examples:

Example: USD/JPY Rate is 91.29
.01/91.29 X USD 10,000 = USD 1.10.  Since the USD is the base currency we do not have to go on and multiply the pip value by the exchange rate (like in the above example).

Don’t worry! We just wanted you to know the correct way to calculate pip value but in reality most trading platforms will tell you automatically the correct pip value of the currency pair you are about to trade.

4. Trading On Margin
There are several unique features in the forex market that attract traders and investors, trading on margin is one of them. Buying or selling on margin simply means that the trader is borrowing money from his broker in order to be able to buy more currency than it would possible with only the traders own money, i.e. buying and selling assets that represent more value than the capital in the traders account. Leverage, in our case, is simply the use of margin to increase the potential return of the currency investment/trade. You have to be able to understand how all this translates into numbers so we will look at an example:

A trader has USD 10,000 in his brokers account. However, he wants to be able to trade USD 100,000, which is 10 times more than his account value, i.e. money he does not have. His broker lends him the full amount which now means the trader is controlling USD 100,000 with only USD 10,000.  In terms of margin, a 10% margin is used, and in terms of leverage a 10:1 ratio is used.

Why 10:1?
10 times 10,000 equals 100,000, or the borrowed amount of money.

Why 10%? USD 10,000 (the amount of money the trader has in his account, money the trader OWNS) is 10% of the total amount of money being used to trade, USD 100,000.
Bottom line, these two numbers bring you to the same outcome, i.e. knowing how much money you can borrow or are borrowing from your broker to execute a trade. When you start searching for a forex broker to work with, you will always see that the broker displays the maximum leverage allowed. Most brokers will allow you a 100:1 leverage, but some will go as high as 500:1! Buying or selling with borrowed money can be very risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price – the potential for greater losses. This issue is important and will be dealt with in the money management section with more detail.

5. The Trade
Placing a trade in the forex market is basically the same as placing a trade in any other market. Some people get confused because they feel they are not buying or selling anything like in the stock market, were you buy or sell part of a company. We will dissect a trade from beginning to end in order to understand what is being done in the process.

Step 1:

The trader has USD 10,000 in his forex broker account.

Step 2:

In the morning the GBP/USD quote is 1.6054. This means that every GBP (Great British Pound) is worth 1.6054 dollars (i.e. 1:1.6054).  Based on his analysis, the trader thinks that within the next 24 hours the GBP will gain strength against the US Dollar (i.e. a single GBP will exchange for more dollars). The trader wants to profit from the speculated move.

Step 3:

The trader places a BUY GBP 100,000 (remember, although the trader does not have that amount of money in the account, trading on margin will allow this transaction) order with his broker either through the phone or through the broker’s on-line trading platform.  At this moment the trader has purchased GBP 100,000 at a cost of 1.6054 USD per GBP. In effect, what has also happened is that the trader sold USD 160,540.

Step 4:

About 12 hours after placing the trade, things turned out as the trader has speculated and the GBP has appreciated in value against the USD and the quote is 1.6154, a difference of 0.0100 (or 100 pips) from the quote 12 hours ago. The trader decides to liquidate the position with the current profit.

Step 5:
In order to close the position the trader has to now SELL the GBP’s he bought earlier and buy back USD. An order to sell GBP 100,000 is placed.  Outcome: The market moved into the direction the trader speculated and a 100 pip profit was achieved. The profit is calculated in the following manner:

Trade Open (rate 1.6054) GBP +100,000
Trade Close (rate 1.6154) GBP -100,000
Profit: USD +1,000
USD -160,540
USD +161,540

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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