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How does Forex Trading Work?

Your broker or institution that you are trading with collects quotes from a centralized feed or individual quotes comprising of interbank rates.

Currencies are traded in pairs and are each assigned a symbol click here for symbols list

Many times you will see the USD quoted first. But the flip side pair may also be quoted too. The first currency quoted is known as the base currency.

When you see FX quotes you will actually see two numbers. The first number is called the bid and the second number is called the offer (sometimes called the ASK). If we use the EUR/USD as an example you might see 0.9950/0.9955 the first number 0.9950 is the bid price and is the price traders are prepared to buy Euros against the USD Dollar. The second number 0.9955 is the offer price and is the price traders are prepared to sell the Euro against the US Dollar. You will also notice that there is a difference between the bid and the offer price and that is called the spread. For the four major currencies the spread is normally between 3 and 5 pips.

To carry on from the symbol conventions and using our previous EUR quote of 0.9950 bid, that means that 1 Euro = 0.9950 US Dollars. In another example if we used the USD/CAD 1.4500 that would mean that 1 US Dollar = 1.4500 Canadian Dollars.

The most common increment of currencies is the pip. If the EUR/USD moves from 0.9550 to 0.9551 that is one pip. A pip is the last decimal place of a quotation. The pip or POINT as it is sometimes referred to depending on context is how we will measure our profit or loss.

As each currency has its own value it is necessary to calculate the value of a pip for that particular currency. We also need to work to our account base currency so let us assume that we want to convert everything to US Dollars.

Example 1. USD quoted as base:

NOTE: Some Forex currencies such as the JPY only quote to two decimal places, most but not all of the other currencies quote to four decimal places

Example JPY rate of 116.73

In the case of the JPY 1 pip would be .01 therefore

USD/JPY: (.01 divided by exchange rate = pip value) so .01/116.73=0.0000856

Now with a four decimal quote:

USD/CHF: (.0001 divided by exchange rate = pip value) so .0001/1.4840 = 0.0000673

USD/CAD: (.0001 divided by exchange rate = pip value) so .0001/1.5223 = 0.0001522

Example 2. USD not quoted as base:

In the case where the US Dollar is not quoted first and we want to get to the US Dollar value we have to add another step.

EUR/USD: (0.0001 divided by exchange rate = pip value) so .0001/0.9887 = EUR 0.0001011 but we want to get back to US Dollars so we make another calculation which is EUR X Exchange rate so 0.0001011 X 0.9887 = 0.0000999 when rounded up it would be 0.0001.

GBP/USD: (0.0001 divided by exchange rate = pip value) so 0.0001/1.5506 = GBP 0.0000644 but we want to get back to US Dollars so we make another calculation which is GBP X Exchange rate so 0.0000644 X 1.5506 = 0.0000998 when rounded up it would be 0.0001.

Spot Forex is traditionally traded in lots also referred to as contracts. The standard size for a lot is $100,000. In the last few years a mini lot size has been introduced of $10,000 and this again may change in the years to come. Check out www.fxcm.com who manage trades in mini Forex.

Currencies are measured in pips, which is the smallest increment of that currency. We need to see how the currency pairs affect the pip value.

Example 3. USD quoted as base:

USD/JPY at an exchange rate of 116.73

(.01/116.73) X $100,000 = $8.56 per pip

USD/CHF at an exchange rate of 1.4840

(0.0001/1.4840) X $100,000 = $6.73 per pip

Example 3. USD not quoted as base:

In cases where the US Dollar is not quoted first the formula is slightly different.

EUR/USD at an exchange rate of 0.9887

(0.0001/ 0.9887) X EUR 100,000 = EUR 10.11 to get back to US Dollars we add a further step

EUR 10.11 X Exchange rate which looks like EUR 10.11 X 0.9887 = $9.9957 rounded up will be $10 per pip.

GBP/USD at an exchange rate of 1.5506

(0.0001/1.5506) X GBP 100,000 = GBP 6.44 to get back to US Dollars we add a further step

GBP 6.44 X Exchange rate which looks like GBP 6.44 X 1.5506 = $9.9858864 rounded up will be $10 per pip.

Your broker may have a different convention for calculating pip value relative to lot size but however they do it they will be able to tell you what the pip value for the currency you are trading is at that particular time. Remember that as the market moves so will the pip value depending on what currency you trade.

So now we know how to calculate pip value lets have a look at how you work out your profit or loss. Let's assume you want to buy US Dollars and Sell Japanese Yen. The rate you are quoted is 116.70/116.75 because you are buying the US you will be working on the 116.75, the rate at which traders are prepared to sell. So you buy 1 lot of $100,000 at 116.75. A few hours later the price moves to 116.95 and you decide to close your trade. You ask for a new quote and are quoted 116.95/117.00 as you are now closing your trade and you initially bought to enter the trade you now sell in order to close the trade and you take 116.95 the price traders are prepared to buy at. The difference between 116.75 and 116.95 is .20 or 20 pips. Using our formula from before, we now have (.01/116.95) X $100,000 = $8.55 per pip X 20 pips =$171

In the case of the EUR/USD you decide to sell the EUR and are quoted 0.9885/0.9890 you take 0.9885. Remember you are now selling and you need a buyer. The buyer is biding 0.9885 and that is what you take. A few hours later the EUR moves to 0.9805 and you ask for a quote. You are quoted 0.9805/0.9810 and you take 0.9810. You originally sold EUR to open the trade and now to close the trade you must buy back your position. In order to buy back your position you take the price traders are prepared to sell at which is 0.9810. The difference between 0.9810 and 0.9885 is 0.0075 or 75 pips. Using the formula from before, we now have (.0001/0.9810) X EUR 100,000 = EUR10.19: EUR 10.19 X Exchange rate 0.9810 =$9.99($10) so 75 X $10 = $750.

When you enter or exit a trade at some point you are subject to the spread in the bid/offer quote. As a rule of thumb when you buy a currency you will use the offer price and when you sell you will use the bid price. So when you buy a currency you pay the spread as you enter the trade but not as you exit and when you sell a currency you pay no spread when you enter but only when you exit. The broker has to get paid somehow.

Leverage Issues and Margin

The minimum security (Margin) for each lot will very from broker to broker. Today it is possible with brokers to get leverage from a high as 1%. This means you could control $100,000 with only $1,000 known as a lot.

Because high leverage is possible with small capital account balances, margin call is something that you will have to be aware of. If for any reason the broker thinks that your position is in danger e.g. you have a position of $100,000 with a margin of one percent ($1,000) and your losses are approaching your margin ($1,000). He will most probably close your position to limit your risk and his risk. If you are going to trade on a margin account it is important that you understand leverage issues.

There have been many discussions on the topic of margin and some argue that too much margin is dangerous. This is a point for the individual concerned. The important thing to remember as with all trading is that you thoroughly understand your brokers policies on the subject and you are comfortable with and understand your risk and that you are comfortable with your trading style and systems.

Forex Rollovers

Most of Spot Forex is traded through London in Great Britain. So we need to reference GMT and so we shall use London time. Most deals in Forex are done as Spot deals. Spot deals are nearly always due for settlement two business days day later. This is referred to as the value date or delivery date. On that date the counterparties take delivery of the currency they have sold or bought.

In Spot FX the majority of the time the end of the business day is 21:59 GMT. Any positions still open at this time are automatically rolled over to the next business day, which again finishes at 21:59GMT. This is necessary to avoid the actual delivery of the currency. As Spot FX is predominantly speculative most of the time the trades never wish to actually take delivery of the actual currency. They will instruct the brokerage to always rollover their position. Many of the brokers do this automatically and it will be in their polices and procedures. Your broker will automatically rollover your position unless you instruct him that you actually want delivery of the currency.

If you are trading on margin, you have in effect a loan from your broker for the amount you are trading. If you had a 1 lot position you broker has advanced you the $100,000 even though you did not actually have $100,000. The broker will normally charge you the interest differential between the two currencies if you rollover your position. This normally only happens if you have rolled over the position and not if you open and close the position within the same business day.

To calculate the broker's interest he will normally close your position at the end of the business day and again reopen a new position almost simultaneously. You open a 1 lot ($100,000) EUR/USD position on Monday 15th at 11:00 at an exchange rate of 0.9950. During the day the rate fluctuates and at 22:00 the rate is 0.9975. The broker closes your position and reopens a new position with a different value date. The new position was opened at 0.9976 a 1 pip difference. The 1 pip deference reflects the difference in interest rates between the US Dollar and the Euro. In the example you are long Euro and short US Dollar. As the US Dollar in the example has a higher interest rate than the Euro you pay the premium of 1 pip.

If you had the reverse position and you were short Euros and long US Dollars you would gain the interest differential of 1 pip. If the first named currency has an overnight interest rate lower than the second currency then you will pay that interest differential if you bought that currency. If the first named currency has a higher interest rate than the second currency then you will gain the interest differential.

If you are long a particular currency and that currency has a higher overnight interest rate you will gain. If you are short the currency with a higher overnight interest rate then you will lose the difference.

Account Reconciliation Issues

Although the movement today is towards all transaction eventually finishing in a profit and loss in US Dollars it is important to realize that your profit or loss may not actually be in US Dollars. However, the trend is more pronounced in the US as you would expect. Most US based traders assume they will see their balance at the end of each day in US Dollars. But the profit quote might have actually been in another currency so take care to reconcile and get your broker's policies on these issues.

Example.

You sell USD/JPY and as such are short USD and Long JPY. You enter the trade at 116.10 and exit 116.90. You in fact made 80,000 Japanese Yen (1 lot traded) not US Dollars. If you traded all four major currencies against the US Dollar you would in fact have made or lose in EUR, GPY, JPY and CHF. This might give you a ledger balance at the end of the day or month with four different currencies. This is common in London. They will stay in that currencies until you instruct the broker to exchange the currency to reflect that you have a profit or loss into your own base currency. Remember you will be converting so this can work for you or against you depending on the rate of exchange when you change back into your home currency. One idea is to trade as much as possible in the base of your trading account to avoid these issues where possible.