BASICS OF FOREX
BASIC CONCEPTS OF FOREX TRADING
BASICS OF FOREX
You have been hearing about forex trading and you want to know what exactly is this forex trading that people talk about? how those it work?. Now on this page we are going to tell you all the basic things you need to know about forex trading.
First of all what is forex: Forex or FX simply means foreign exchange, what exactly are we exchanging? Exchanging one currency for the other. Sometimes we involve in forex trading in our day to day activity without knowing, you don’t necessary need to be a trader to participate in the foreign exchange market. For instance when you travel to a different country that does not use your currency and landing on the airport you were very hungry and need to eat something but, you can’t buy any food or snacks to eat because you are still with your country’s currency so you need to exchange it with your new country’s currency. Now going to the airport’s foreign exchange desk and exchange your country’s currency to the new country’s currency, doing this you have simply participated in forex trading.
What does forex trade: in the forex market we trade currencies, (i.e we buy and sell currencies ). And you may even earn a profit, according to which currency pair you exchanged. This is why we call it foreign exchange. Depending on the currency rates and market movements, you can make profit it all depends on how alert and how economies change. Remember do not confuse forex trading with physical trading- it’s all online! You buy a currency online, sell another online, and you make your profit online. If you have a forex trading account all your profit (money) will always be available there, you can withdraw your profit to your personal bank account at anytime and finally cash it out if you want.
In forex we trade currencies in pairs and we use symbols to represent them. How does currency pairs work? Trading always consist of buying one currency and selling another. Together these currencies make up a currency pair. Imagine choosing the USD/JPY pair. You expect the USD to increase in value as compared to JPY. So you buy USD and sell JPY. Remember in other to buy one currency you have to sell another. If the USD rises against the JPY, you close the position and take your profit. Why is forex trading done in currency pairs? Imagine that the first currency in any currency pair (in our example USD) in a potato. So in order to buy a potato, you need to buy some certain amount of the second currency (in our example JPY). There are two categories of: major, minor, exotic.
Majors: major currency pairs are traded most frequently, and they contain major currency pairs are traded most frequently, and they contain the US dollar (USD).
Minors: minor currency pairs don’t contain the USD. The most active ones contain EUR, JPY, and GBP.
Exotics: exotic currency pairs contains one major currency as the base currency, paired with any non-major currency, such as South African rand, Mexican peso, or Danish krone. Exotic pairs are not so widely traded.
Trading styles: the beauty of forex among other trading is that you can do it anywhere, anytime and you are free to choose your own trading style and trade according to your own knowledge and risk tolerance. There are four trading style which is Intraday trading, Swing trading, position trading and Scalping.
Intraday trading is when you hold positions for a short time (from minutes to hours), make many trades a day, and usually enter and close your trades on the same day.
Swing trading: swing trading is similar to intraday treading but it has a longer trading horizon between hours to few days.
Position trading: this means when you hold position for a long time (from weeks to years). It’s the opposite of intraday trading because you are more interested in long-time investment than in short-time price change.
Scalping: is very short-time trading. You try to make many small profits during a single trading day.
Learning a foreign language starts with the alphabet, and so does forex. Forex has its own terms that serve as its language making it easy for traders to interact with the market.
Currency Pair: this is the quotation of one currency unit against another currency unit. For example the EUR/USD, and in this currency pair there is what we call the base and the quote currency, the first currency in the pair is the base currency while the second currency is the quote currency
Exchange Rate: this is the rate at which you exchange one currency to another. The exchange rate shows you how much of the quote currency you need if you want to buy unit of the base currency. Example EUR/USD=1.3119 this means that 1 euro is equal to 1.3119 US dollars.
Quote: it is a market price that always consist of two figures: the first figure is the bid/selling price, and the second the ask/buying price. (e.g 1.23458/1.12347)
Ask Price: also known as the offer price, the ask price is the price visible at the right hand side of a quote. This is the price at which you can by the base currency. While the Bid price is the price at which you can sell a currency pair. Bid is always lower than ask. And the difference between ask and bid is the spread.
Spread: it is the difference in pips between the ask price and the bid price. The spread represents the brokerage service costs and replaces transaction fees. There are fixed and variable spreads. Fixed spreads maintain the same number of pips between the ask price and the bid price, and are not affected by market changes. While variable spreads increase and decrease according to the liquidity of the market.
Account currency: this is the currency you choose when you open a trading account with any broker, it can be your local currency and your profits and losses will be converted into that particular currency.
Pip: a pip is the smallest price change of a given exchange rate. Example if the currency pair EUR/USD moves from 1.2550 to 1.2551, that’s a 1 pip movement; or a move from 1.2550 to 1.2555 is a 5 pip movement. And as you can see, the pip is the last decimal point. All currency pairs have 4 decimal point except the Japanese yen (JPY) which has only 2 decimal points.
Lot: forex is traded in amounts called lots. One standard lot has 100,000 units of the base currency, while a micro lot has 1,000 units. For example if you buy 1 standard lot of EUR/USD at 1.3125, you buuy 100,00 Euros and sell 131,250 US dollars. Similarly, when you sell 1 micro lot of EUR/USD at 1.3120, you sell 1,000 Euros and you buy 1,312 US dollars.
Pip Value: the pip value show how much 1 pip is worth. The pip value changes in parallel with market movements. So it is good to keep an eye on the currency pairs you are trading and how the market changes. Now let’s reflect on what you have learnt about pips! To benefit from pips and see significant an increase/decrease in profit, you will need to trade larger amounts. Suppose you account currency is USD and you choose to trade 1 standard lot of USD/JPY. How much is one pip worth per $100,000 on the USD/JPY currency pair? The calculation formula is as follows: amount x 1 pip= 100,000x0.01 JPY = JPY 1,000 if USD/JPY = 130.46, then JPY 1,000 – 1,000/130.46= USD 7.7 therefore, the value of 1 pip in USD/JPY is equal to: (1 pip, with proper decimal placement x amount/exchange rate)
Margin: margin is the minimum amount of funds, expressed as percentage that you will need if you want to open a position and keep your position open. If you trade on 1% margin, for what instance, for any USD 100 that you trade, you need to put down a deposit of USD 1. And so, in order to buy one standard lot (i.e 100,000 of USD/CHF), if you need to maintain only 1% of traded amount in your account i.e USD 1,000 but how can you buy 100,000 USD/JPY with only USD 1,000? Basically, margin trading involves a loan from the forex broker to the trader. When USD 1,000 but how can you buy 100,000 USD/JPY with only USD 1,000? Basically, margin trading involves a loan from the forex broker to the trader. When you carry out a forex transaction, you don’t actually buy all the currency and deposit it into you trading account. Practically speaking what you do is speculate on the exchange rate. In order words, you estimate how the exchange rate will move, and you made a contract based agreement with your broker that he will pay you or you pay him depending on whether you estimation has proved to be correct or wrong. If you purchase a USD/JPY standard lot, you don’t need to put down 100,000USD as the full value of your trade. Instead, you will have to put down a deposit that we call margin. This is why margin trading is trading with borrowed capital. In order words, you can trade with a loan from your broker, and that loan amount depends on the amount you initially deposited.
Leverage: strictly speaking, through leverage the broker lends you money so that you can trade bigger lots: leverage depends on the broker and flexibility. At the same time, Leverage varies: it can be 100:1, 200:1 or even 500:1. Remember that with leverage you can use $1,000 to trade $100,000 (1,000x100) or $200,000 (1,000x200) etc. this sounds great, but how does it actually work? I open a trading account and I get a loan from my broker as simple as that?
How does this works? You open a trading account that has a leverage of 1:100. You want to trade a position worth $500,000 but you only have $5,000 in your account. No worries, your broker will lend you the remaining $495,000 and sets aside $5,000 as your good faith deposit. The profits that you make by trading will be added to your account balance or if there are losses, they will be deducted. Leverage increases your buying power and can multiply both your gains and losses.
Equity: it is the total amount of money in your trading account, including your profits and losses. For instance, if you deposited USD1,000 in your account and also made a profit of USD3,000 your euity is amount to USD 13,000
Used Margin: it is the amount of money kept aside by your broker so that your current trading positions can be kept open and you don’t end up with a negative balance.
Free Margin: it is the amount of money in your trading account with which you can open new positions. Free margin = equity-used margin. This means that if your equity is $13,000 and your open positions require $2,000 margin (used margin), you are left with $11,000 (free margin) available to open new positions.
Margin Call: margin call are major part of risk management: as soon as your equity drops to a percentage of the margin used, your forex broker will notify you that you need to deposit more money if you want to maintain your position.
Position: it is a trade that you hold open during a certain period of time. There is two types of position, long and short position. Long position is to buy a base currency while short position is to sell a base currency.
Close Position: if you enter a long (buy) position and the base currency rate has gone up, you want to get you profit. To do so, you must close the position.
Order Types: market order/entry order it is an order to buy o sell currency instantly at the current price.
Open Order: it is an order to buy or sell a financial instrument (e.g forex, stocks or commodities like oil, gold etc) that will stay open until you close, or have your broker close it for you
Limit Order: it is an order placed away from the current market price assuming that EUR/USD is traded at 1.34. you want to go short (place a sell order on this currency pair) if the price reaches 1.35, so you place an order for the price 1.35. this order is called limit order. So your order is placed when the price reaches the limit of 1.35. A buy limit order is always set below the current price whereas a sell limit order is always set above the current price.
Stop-entry order: it is an order that you give to buy above the current price or an order to sell below the current price when you think the price will continue in the same direction. It is the opposite of limit order.
Take Profit (TP): it is an order that closes your trade as soon as it has reached a certain level of profit
Stop-Loss Order (SL):top-Loss Order (SL): it is an order to close your trade as soon as it reaches a certain level of loss. With this strategy, you can minimize your loss and avoid losing all your capital.
Execution: it is the process of completing an order. When you place an order, it will be sent to your broker, who decides whether to fill it, reject it, or re-quote it. Once your order if filled, you will receive a confirmation from your broker.
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