Forex or FX, short for foreign exchange and foreign currency trading is the buying or selling of one currency in exchange for another. Forex instruments are offered as currency pairs in the form of Base Currency / Counter Currency, for example GBP/USD, USD/JPY or EUR/USD. Every currency pair is traded in the units of the Base Currency.
Currency pairs are ratios that tell a buyer or seller how much Counter Currency is required to buy a single unit of the Base Currency. A GBP/USD price of 1.3002/1.3006, means that it takes 1.3006 USD to purchase one GBP. Conversely the sale of one GBP will yield 1.3002 USD. A Dollar/Yen (USD/JPY) price of 116.00/116.03 means that 116.03 Japanese Yen are needed to buy one USD and the sale of one USD will bring 116.00 Japanese Yen. This method of quoting is called a ‘BID/ASK’ or ‘two-way price’. The difference between the two prices is called the ‘spread’ and it varies with the currency pair.
The simultaneous display of both sides of a FX price is a key component of currency trading and has its origin in the way bank traders quoted currency prices by offering to buy and sell at the same time at a set price. The BID is quoted first, the ASK second. The BID price is the level where the price maker is willing to buy the Base Currency and the ASK is where the price maker is willing to sell the Base Currency. This is the way all prices are displayed on the WorldWideMarkets trading platforms.
In the GBP/USD example above 1.3002 is the BID and 1.3006 is the ASK. When a trader wants to buy GBP, also referred to as “going long”, the trader will pay the ASK price, here 1.3006. If a trader wishes to sell GBP, also known as “selling short or going short”, then the trader will sell at the BID price, 1.3002.
A long position (BUY) in GBP/USD with a current market rate of 1.3002/1.3006 will be opened at the ASK price of 1.3006 and a short position (SELL) in GBP/USD will be initiated at a price of 1.3002.
Another important concept in Forex is Leverage or Margin. Leverage refers to the practice of taking a long or short position in an instrument while only being required to supply a fractional portion of the position’s total order price as collateral. The balance of the capital required is supplied by the broker or market maker in what is effectively a loan.
Leverage permits a trader to take larger positions than possible with a straight 1 to 1 ratio of equity to position. The amount of Leverage is expressed as a fraction or percentage. The smaller the fraction or percentage the smaller the amount of customer equity needed to support the position and the greater the amount of capital provided by the broker or market maker.
This form of Forex trading is known as buying or selling on Margin. Your margin for a given trade is the amount of account equity required as collateral on deposit with a broker or market maker throughout the life of the position.
Margin is offered in a number of standard configurations: 400/1 (0.0025%), 200/1 (0.005%), 100/1 (0.01%) and 50/1 (0.02%) are the margin levels offered by WorldWideMarkets.
Let’s look at the 400/1 example. At this margin level a trader is required to keep 1/400th (0.0025%) of the total amount of a position on deposit with the broker or market maker for the life of the trade. If a trader “BUYS“ 10,000 units of GBP/USD at a price of 1.3002/1.3006 the total margin amount for the position at 400 to 1 leverage is 32.52 USD (1/400th of 10,000 x 1.3006 or 0.0025 x 13,006 USD).
The amount of margin required to support a position varies with the trading rate of the currency. If GBP/USD moved higher to 1.3102/1.3106 the required margin would be 32.77 USD (10,000 x1.3106 x0.0025). At 200 to 1 leverage the original position would require 65.03 USD in margin.
Understanding margin is important not only for managing your individual trades, but also for managing your entire account. The WorldWideMarkets trading platforms calculate the amount of ‘Used Margin’ for each individual position and in total, in real time. This ‘Used Margin’ is the amount of account equity required to support all open positions. It is subtracted from the total amount of account equity on deposit and the remainder is ‘Available Margin’. These are the funds that can be used to open new positions. ‘Used Margin’ is unavailable for trading until the positions that it supports are closed and the profit or loss is adjusted against the trading account.
Premiums are another important concept when trading Forex. Premiums are interest payments that a given position may pay or earn when being held through the trading day roll over. Roll-over refers to the closing of every open position at the end of each trading day and the subsequent re-opening of the same position for the next day. The roll takes place at 5:00 pm New York time by market convention. When this occurs the interest that has been earned or indebted on each open position is reconciled to the trading account. The amount of interest is calculated by taking the difference between the interest rate of the Base Currency and the Counter Currency and calculating the difference across the number of units held for a given position. Specifically, with a BUY or long position you subtract the Counter Currency interest rate from the Base Currency interest rate. If the amount is positive, your account is credited the amount. If the amount is negative then your account is debited. On a SELL order or short position you subtract the Base Currency interest rate from the Counter currency interest rate to determine if your account is credited or debited.
Lastly, it is imperative that a trader knows how to determine the profitability of their trades. This is referred to as Profit & Loss, P/L for short. Calculating P/L is done by taking the difference between a position’s opening price and closing price and multiplying it across the size of the position.
For example, take a short position of 10,000 USD/JPY opened at a BID price of 118.96 (10,000 x 118.96 JPY = 1,189,600 JPY). A day later that position is closed at a ASK rate of 118.93 JPY (10,000 x 118.93 JPY = 1,189,300 JPY).
In effect the trader received 1,189,600 JPY when the position was opened and paid out 1,189,300 JPY when the position was closed. The difference is 1,189,600-1,189,300=300 JPY. The trader made a profit of 300 JPY on the trade. Another way to do the same calculation is to take the difference between the two deal rates, 118.96-118.93= 0.03 and multiply it by the position size, 10,000, giving 300 JPY.
But how much is that in USD? To find the answer you must convert the 300 JPY to USD by dividing by the number of JPY equal to one USD. The conversion is buying USD so the ASK rate at the close is used, 118.93, giving a profit of 2.52 USD (300 /118.93=2.52). The trade yielded a $2.52 dollar profit.
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