Forex Trading Basics -- Tutorial 1

As part of an introduction, this section will cover Forex Trading concepts including what is a currency pair, relative currency price movement, price quotes as relating to Forex, and Forex Leverage.

Forex Trading falls within the family of financial products such as ETFs, mutual funds and equities. When trading stocks, the trader has to decide on the direction and the value of stocks going up or down. Stock traders have only to decide what stock will go up or down and then trade accordingly. Currency trading is more complex than stock trading. For example, a FX trader will have to plan which currency will go up or down, and then decide what he will use as the counter currency, or opposite currency.

Knowing what currency will go up, knowing what currency will go down, and knowing by how much either currency will gain against others is the key to finding good setups to currency trading. Finding the right opportunities to pick winning FX trades comes down to knowing and betting on which one country’s currency value will gain value in relation to a second country’s currency losing value.
Currencies are Traded in FX Pairs

By far the most commonly traded pair is the Euro/US Dollar pair. In this example the “EUR” is short for Euro, and the “USD” is short for US dollar. Some commonly traded Forex pair examples are the US dollar/Swedish Kroner pair, known as “USD/SEK”; Australian dollar/Japanese yen pair, known as “AUD/JPY”; and the Great British Pound/Swiss Franc pair known as the “GBP/CHF”.

Go Long a Currency that Will Get Stronger

In other words, with the EUR/USD, a trader who believes the US dollar will be trending down in value against the Euro in the next trading sessions, would want to set up his FX trades by selling (shorting) USD and buying up (going long) EUR. All Forex Trades follow this concept, regardless of currency pair: if it is thought that one currency is getting stronger, then buy (go long) that currency and sell or (short) the counter currency of the pair that is getting weaker.

The Concept of “Gearing of Leverage”

Gearing. Leverage. Margin. These are the keys to the huge wins that can be had in Forex trading. Margin can be a factor of 10x, 20x, 50x or higher. In the following example, the trader has a cash balance of $100US in his account. The FX trader amplifies his buying power by “setting” his margin to 50:1 or 50x his cash balance. He can then buy $5,000US of currency or $100US x 50 = $5,000US.

How Leverage Works in a Forex Trade

Taking his purchasing power of $5,000US, he sells the currency he thinks will lower in value relative to another currency. He will use the proceeds of the shorted currency “sale”, in this case, the USD, to go ahead and “buy” the currency he thinks will increase in value. For this particular example, it is the Euro, or “EUR”. This means the trader sells or “goes short” on USD and buys or “goes long” on EUR. As complex as this all appears, computer software programs called FX trading platforms easily calculate real time ratios as they process the trader’s buying power in seconds.

Using the instantaneous difference of exchange rates of the paired currencies, the trader can estimate how much he can buy. Therefore, if he decides to use $1,500 to “sell short” USD, he will have created $1,500 worth of buying power to buy or “go long” on EUR. So, if the exchange rate is at $1.25USD to 1.00EUR, the trader exchanges his $1,500USD for 1,200EUR (1,500/1.25 = 1,200).
Money is made when the price of the EUR is greater than 1.00EUR/1.25USD.

How “Gains” are made with Forex Trades

When will a FX trade be a gain, and a profitable trade? A gain is created when the trader “closes out” or reverses the trade on the EUR/USD example from above. In this example, the FX Trader would take his 1,200 EUR to sell them (close out his position) and then use the cash margin to pay off the balance on the “borrowed” (shorted) USDs in which he originally made the trade. For this example, the trader takes the 1,200 Euros and turns them back to US dollars to cover his initial cash outlay.

The gain is made when the new exchange rate is different than when he originally started the trade. When he first moved his US dollars to buy the Euros, the rate was 1.25EUR/$1.00USD. In this example the new rate is now 1.35EUR/$1.00USD. Multiply 1,200EUR x 1.35 to get $1,620 US dollars. While the trader originally “shorted” the $1,500 dollars, he now has $1,620 dollars. The Forex brokerage software will automatically pay down the shorted funds, leaving the remaining monies ($1,620USD -$1,500USD = $120USD) into the account as profit.

How Actual Percentage Gains vs. Forex Account Cash Balances Are Calculated

Now is the time to figure out exactly how much the Forex trader has made with the above scenario. By leveraging 50:1 of the cash balance, the trader has made $120USD in profit with an actual cash balance of $100USD. Setting a 50:1 leverage allowed the trader to multiply his potential returns as measured against actual cash outlay. The return is valued at 120% on the trader’s investment of $100USD ($120USD Profit/$100USD actual Cash Deposit = 120%). This gain is derived from an 8% [((1.35EUR – 1.25EUR)/1.25EUR) = 8%] gain in EUR value. A more accurate typical daily change in value of the EUR/USD pair would be plus or minus 0.25% - 1.00% in either direction.

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