INTRO TO FOREX
Find answers to the most popular questions regarding trading with OliveFX
The foreign exchange (also referred to as ‘forex’ or ‘FX’) market is the largest financial market in the world, with over $5 trillion traded every day. The forex market allows you to take advantage of currency rate fluctuations. It involves the simultaneous buying and selling of two currencies or what’s known as a currency pair. Currency pairs include a base currency and a counter or quote currency. The most traded currency pair globally is EUR/USD (Euro/US Dollar) where Euro is the base currency (first quoted) and US Dollar is the counter currency (second quoted). You can either go ‘long’ which involves simultaneously buying the Euro and selling the US Dollar if you believe the Euro will strengthen against the US Dollar. Alternatively, if you believe the Euro will weaken against the US Dollar you can go ‘short’ where you would sell the Euro and buy the US Dollar.
Forex trading has recently become increasingly popular with private investors and traders as they discover the opportunities the market has to offer. Some of the benefits are:
- Trade on rising and falling markets (going long or short)
- High liquidity tends to keep spreads tight meaning trading costs are low
- 24-hour trading as the product is not traded on a centralised exchange
- Using leverage to trade on margin
- Trading opportunities as prices are constantly fluctuating with volatility
Forex is traded using ‘leverage’, which means you can use a small amount of money to trade a much bigger position. The terms leverage and margin are interchangeable as 100:1 leverage is the same as 1% margin or 400:1 leverage would equal a margin of 0.25%.
If you were buying a 100,000 position on AUD/USD with 400:1 leverage the margin requirement would be A$250.
Using leverage magnifies profits but also losses so make sure you understand this concept and manage your risk accordingly.
Pips are used as the unit of measurement to describe the change in value of a currency pair. A pip is usually the 4th number after the decimal place but there are some exceptions such as the Japanese Yen where it is the 2nd number after the decimal place.
When EUR/USD moves from 1.1400 to 1.1401 it means the pair has risen by 0.0001 or 1 pip. Most platforms will quote a currency pair to 5 decimal places allowing for fractional pips.
Pips are always based on the counter currency (second quoted) and the value of a pip depends on the size of the trade.
Forex pairs are traded in lot sizes, this is the amount of the currency you wish to buy or sell. Lot sizes are based on the base currency (first quoted). This will determine the margin required to place the trade and also the value of a pip.
A standard lot in FX is 100,000 units, which would equal 1.0 on the MT4 platform. One of the great aspects of forex trading is that you can trade in a range of different trade size. A mini lot is 10,000 units and would be the same as trading 0.1 on MT4. The smallest trade size is a micro lot which is 1,000 units or 0.01 on MT4.
Trading a standard lot means that each pip is worth 10 units of the counter currency. For example, trading 1 lot of EUR/USD would mean that each pip is worth USD$10. Similarly, a mini lot of 10,000 units gives a pip value of 1 unit or $1. A micro lot means that each pip is worth 0.1 unit or 10 cents in this example.
When buying a currency pair, traders will look at the ask price and when selling are only concerned with the bid price. The bid will always be lower than the ask price. The difference between the bid and the ask price is called the ‘spread’. This is measured in pips.
For example, when the EUR/USD price is quoted at 1.13584/1.13596, the spread is 1.2 pips
In forex trading there are specific terms for different types of orders. The following are available on the MT4 platform:
Market Order: Market orders are used to buy or sell a currency pair at the best current available price
Pending Order: Pending orders are used to execute trades at a pre-defined price in the future but only if the market reaches the specified price. There are 4 types of pending order:
Buy Stop – when the current price is lower than the pending order level. These are typically used when a trader believes that if the market rises to a certain level it will continue to increase.
Buy Limit – when the current price is higher than the pending order level. These are typically used when a trader believes the market will fall to a certain level then increase.
Sell Stop – when the current price is higher than the pending order level. These are typically used when a trader believes that if the market falls to a certain level it will continue to decrease.
Sell Limit – when the current price is lower than the pending order level. These are typically used when a trader believes the market will rise to a certain level then decrease.
Stop Loss – Stop loss orders can be used to minimise losses. If the currency pair reaches the pre-defined level the trade will be closed automatically. This allows the trader to reduce risk to a more acceptable level for them specifically. When in a long position the stop loss will be below market price. When in a short position the stop loss will be above market price. This order is connected to a market or pending order and are extremely important in managing risk.
Take Profit – Take profit orders are designed to realise a profit if the market moves in the trader’s favour. The order will be executed automatically if the price reaches the specified level and is essentially the opposite of a stop loss as the aim of this order is to close out a winning trade at a pre-defined level. When in a long position the take profit will be above market price. When in a short position the take profit will be below market price. This order is connected to a market or pending order.
When you hold a forex trade overnight a swap or rollover interest will be incurred. Swap rates are based on the interest rate differentials between the countries involved in a currency pair and whether the trade is long or short. The interest is received on the currency bought and paid on the currency sold.
Typically, when you are holding the currency with the higher interest rate or yield you will receive rollover interest. If you are holding the currency with the lower yield then you will pay rollover interest.
It is important to note that if you hold the trade over the weekend then on Wednesday a triple swap rate is applied due to settlement taking place two business days from the trade date.
Swap rates can be viewed on the MT4 platform by right clicking on the pair in Market Watch then selecting Specification. If you don’t already have the relevant pair in Market Watch, click View from the top drop-down, click on Symbols, then select the pair you are interested in and click Properties.
It’s important to remember that margin is calculated in the base currency whereas profits/losses are calculated in the counter currency.
Profits/losses are calculated by taking the difference between the open and close price and multiplying this by the lot size traded.
OliveFX will automatically convert figures back to your account currency.
- The trader, who has a USD account currency with 400:1 leverage, believes the Euro will appreciate against the US Dollar so buys 1 lot (100,000) of EUR/USD at 1.1308
- Margin required = €100,000 / 400 = €250 which would be converted to $282.70 (250 x 1.1308)
- The market rises and the trade is closed at 1.1398, 90 pips above the entry price
- Profit = (1.1398 – 1.1308) x 100,000 = $900
- Another way to calculate this is by using pip values. Each pip in this example is equal to $10 because the trader bought one lot. Multiplying 90 pips by the pip value gives us the $900
- The trader has an AUD account currency with 200:1 leverage and sells 0.1 lots of AUDUSD at 0.7198
- Margin required = A$10,000 / 200 = A$50
- The position hits the trader’s take profit order and is closed at 0.7174
- Profit = (0.7198 – 0.7174) x 10,000 = $24
- Convert to AUD at 0.7174 = A$17.22
The trader has a USD account currency with 100:1 leverage and buys 0.5 lots of EUR/GBP at 0.8745.
- Margin required = €50,000 / 100 = €500 which, assuming EUR/USD is currently 1.1350, would be converted to $567.50
- The position goes against the trader and hits the stop loss order at 0.8689
- Loss = (0.8745 - 0.8689) x 50,000 = £280
- Converting this to USD, assuming a GBP/USD rate of 1.3125, would mean a loss of $367.50
The trader has a USD account currency with 50:1 leverage and buys 5 lots of USD/JPY at 113.08
- Margin required = $500,000 / 50 = $10,000
- The trader closes the position for a profit at 113.92
- Profit = (113.92 – 113.08) x 500,000 = ¥420,000
- Convert to USD at 113.92 = $3,686.79
Given the forex market is traded on leverage it is imperative you are aware of the risks associated. The keys to managing this risk are using stop loss and take profit orders and not over-leveraging yourself.
Using stop loss orders effectively will reduce the risk on each trade to a level that is fine for you to accept. If you only want to risk $100 on a trade take a position size relevant to this depending on where you want to place your stop loss order.
For example, when placing a long trade, you accept EUR/USD may drop by 50 pips to a support level then buy a position of 20,000 where each pip is worth $2. Similarly, if you want to make double the amount you are willing to risk you should place a take profit order 100 pips above the market.
It is always worth keeping in mind the risk to reward ratio. By aiming to make more than you are willing to risk you can get half your trades correct and be in profit overall. A risk to reward ratio of 1:2 or 1:3 is common with successful traders.
Leverage is also a key factor in managing risk. It is important you monitor the margin level on your account so that it doesn’t fall too low where you may receive a margin call or stop out. Over-leveraging means taking on too big a position for the size of your account and can quickly deplete your trading account if the trade goes against you. Remember leverage magnifies both profits and losses so needs to be managed effectively.