If you’ve ever traveled internationally, you’ve touched the world of currency trading, although you may not know it: when you got off the plane, one of your first stops was probably to exchange your money for local currency.
Definition of foreign exchange operations
Forex, or FX, refers to the currency market, which is where investors can buy and sell currencies from around the world. It is the largest financial market in the world, but one that many individual investors have never entered, in part because it is highly speculative and complex.
A little healthy restlessness serves investors well. Active trading strategies and complex investment products have no place in most portfolios. Financial advisers often highly recommend low-cost index funds for long-term goals like saving for retirement.
But maybe you have a balanced portfolio and are now looking for an adventure with some extra cash. As long as you know what you are doing, take those words seriously, forex trading can be lucrative and requires limited initial investment.
Understand currency trading
The concept of currency trading can be difficult to understand. Here’s how it works: currencies are always traded in pairs, like the euro and the US dollar. When you trade forex, you always buy one currency and sell another (which is why currencies are always traded in pairs as well).
Currencies rise and fall at different rates (for example, the euro can rise while the US dollar falls) based on geopolitical or economic factors, such as natural disasters or elections. Based on those kinds of factors, you might think that a related currency, for example the euro, will increase in value. You can then buy euros and sell US dollars. If your prediction came true and the euro rose in value, you would make a profit. Of course, there are many more nuances that make currency trading complex, which we will look at next.
Current currency trading rates
The chart below shows two paired currencies and reflects what one unit of the first listed currency is worth in the second listed currency. For example, the first row shows how much a euro is worth in US dollars.
Forex trading quotes are pulled from Google Finance and can take up to 20 minutes. The data is for informational purposes only, not for commercial purposes.
How to read a forex quote
Being able to actually read and understand a forex quote is, unsurprisingly, the key to trading forex. Let’s start with an example of an exchange rate: EUR / USD 1.12044.
The currency on the left (EUR) is the base currency and is always equal to one unit: € 1, in this example.
The currency on the right (USD) is called the listing or over-the-counter currency.
The number is the value of the OTC currency relative to one unit of the base currency. When that number goes up, it means that the base currency has risen in value, because a unit can buy more of the opposite currency. When that number goes down, the base currency has fallen. In this example quote, € 1 equals $ 1.12044.
You are always buying or selling the base currency. Within a pair, one currency will always be the base and the other will always be the counter, so when trading USD, the EUR is always the base currency. When you want to buy EUR and sell USD, you would buy the EUR / USD pair. When you want to buy USD and sell EUR, you would sell the EUR / USD pair.
Bid and ask prices
As with stock trading, buy and sell prices are key to a currency’s price. They are also tied to the base currency and get a bit confusing because they represent the dealer’s position, not yours. The bid price is the price at which you can sell the base currency; in other words, the price that the merchant will “bid” or pay for it. The sell price is the price at which you can buy the base currency, that is, the price at which the merchant will sell or “ask” it.
The sell price tells you how much of the counterpart currency (USD, in our example) it will take to buy one unit of the base currency (EUR).
The offer price tells you how much of the OTC currency you can buy when you sell one unit of the base currency.
The difference between these two prices, the selling price minus the bid price, is called the spread.
Supply and demand are normally displayed as EUR / USD supply / demand, and demand is represented by only the last two digits. For example, EUR / USD 1.12044 / 57 means that the supply is 1.12044 and the demand is 1.12057. You could sell € 1 for $ 1.12044 (the offer) and buy € 1 for $ 1.12057 (the offer).
The bid price is always lower than the bid price, and the tighter the margin, the better for the investor. Many brokers increase or extend the margin by increasing the sale price. They then pocket the extra instead of charging a set business commission.
The last highlight about pricing is that the spread, profit, and loss are measured in a unit called a pip.
What is a pip?
Remember when we said that currency trading was complex? We weren’t lying. In stock trading, you may hear or read that the price of a stock went up one point, or $ 1. A pip is the forex version of a point – the smallest price movement within a currency pair.
The value of a pip depends on the trade lot and the currency pair. If you are trading a pair that has the USD as the counterpart currency and you are using a dollar-based account to buy and sell, the pip values are:
Micro lot (1000 units): pip = 10 cents.
Mini lot (10,000 units): pip = $ 1.
Standard lot (100,000 units): pip = $ 10.
If USD is the base currency, the pip value will be based on the counter currency, and you will need to divide these values for micro, mini and standard lots by the exchange rate of the pair.
To find out how many pips are in the spread, subtract the bid price from the bid price – that gives you 0.00013 in our EUR / USD example. For most pairs, the smallest price movement occurs in the fourth digit after the decimal, so the spread here is 1.3 pips, or $ 1.30 on a mini lot. That is the cost of the exchange.
Understand the size of forex lots
Forex is traded in “batches”. A micro lot is 1000 units of currency, a mini lot is 10,000 units and a standard lot is 100,000 units. The larger the lot size, the greater the risk you will take; individual investors should rarely trade standard lots. If you are a beginner, we recommend sticking to micro batches as you get going.
This seems like a good place to point out that reputable forex brokers almost always give investors access to a demo trading account. It is much more fun to lose play money than real money, especially while learning the rules.
How Forex Investors Make (and Lose) Money
As noted at the beginning of this post, currency trading is risky. You are betting that what you buy will increase in value. With forex, you want the currency you are buying to increase relative to the currency you are selling. If you bought a mini lot of a coin and its value increases 1 pip, your investment would be worth $ 1 more. If you go down 1 pip, your investment would be worth $ 1 less.
That’s pretty easy to understand – after all, whether you’re buying a house or the euro, you want what you buy to be worth more than what you paid for it. Where things get tricky is the leverage mentioned above.
Using your leverage
Leverage allows you to borrow money from the broker to trade more than the value of your account. Many brokers offer up to 50: 1 leverage on major pairs, which means you can initiate trades up to 50 times larger than your account balance.
Let’s go back to our previous example. Let’s say you want to buy EUR / USD at 1.12044 / 57. To trade a mini lot, or 10,000 units, you would have to pay $ 11,205.70 for 10,000 euros. You may not want to invest as much in a trade, so you would use leverage to enter the position with a smaller amount:
The 10: 1 leverage would require $ 1,120.57 from your account (one-tenth of the trade value).
The 20: 1 leverage would require $ 560.29 (one twentieth of the trade value).
The 50: 1 leverage would require $ 224.11 (one-fiftieth of the trade value).
The positive? Because currency movements are typically small but frequent, often below 100 pips per day, leverage allows you to buy more with less cash up front, increasing your performance if the currency you are buying rises.
The downside, you may have guessed, is that leverage also increases your losses if the currency you are buying goes down. The more leveraged your account is and the larger the lot size you are trading on, the more exposed you are to a dip.
Currency Trading vs. Stock Trading
Forex trading takes place over the counter: merchant to merchant or via forex brokers or distributors, rather than through a central exchange.
Because traders work in different time zones, the forex market is open 24 hours a day, five days a week.
Currency prices fluctuate rapidly but in small increments, making it difficult for investors to make money on small trades. That is why currencies are almost always traded with leverage or money borrowed from the broker.