What is Forex?
Forex, also known as Foreign Exchange, FX or currency trading, is a centralised exchange where all traditional Fiat currencies are traded. The FX market itself is very liquid with a combined total daily volume in excess of $5 trillion. To put it simply, the act of trading Forex is the act of buying or selling one currency against another with the aim of predicting each currencies future value in an attempt to make a profit or minimise loss. The Forex Exchange market is open 24 hours a day, 5 days week.
Institutional VS Retail Trading
As most people are aware, Foreign Exchange has typically been the preserve of large institutions such as Investment Banks and Hedge Funds who regularly place large buy and sell orders with the aim of managing investments as well as hedging exposure to the volatility of a given currency and its susceptibility to external market influences. We call this institutional trading.
In recent years, the Forex market has opened up to anyone with an interest in placing orders on an individual basis through a private trading account held with a Broker of their choice who provides access to this centralised exchange. This means that essentially anyone with access to a computer and the relevant software is able to join in and begin trading for themselves. We call these clients, retail traders.
Needless to say, the main difference is the size of the orders placed, with institutional traders placing orders for hundreds of million dollars.
Currency Pairs
The currency pairs available for trading are typically any monetary currency that doesn’t have it’s value pegged to another currency by a Central Bank. This typically means that all the popular pairs which feature a level high of volatility and thus can be very profitable if successful can be traded against each other on the open market. Well known examples are the EUR/USD and USD/JPY.
Pips
Pip stands for ‘Point in Percentage’. Every currencies value against another is given as a number containing decimal places. GBP/USD 1.3000 would mean that £1 is worth exactly $1.3. To actually know whether a given pair has increased or decreased in value, we measure its movement in pips.
If at 12pm the price of GBP/USD is 1.30000 and at 1pm it is 1.30500, the GBP would have gained 50 pips
or 0.5 cents on the dollar within that hourly time frame.
The forth digit after the decimal place denotes the change in pip value, hence 1.30050 would be an increase of 5 pips. If you were expecting this pair to increase in value you would be buying the asset (or going long). If you were expecting this pair to decrease in value you would be selling the asset (or shorting).
Pip Value
The amount gained or lost in monetary terms due to this pip movement is dependent upon the value of the pip itself, determined by lot size which we shall cover shortly.
Money Management & Lot Sizing
The amount of capital within your trading account will determine the size of each trade or order that you will be able to place with your Broker. When we refer to the size of each order we intend to place, we use the term ‘lot size’.
A lot is a unit of currency which tells us exactly how much we are intending to buy or sell.
Standard lot – 100,000 units
Mini lot – 10,000 units
Micro lot – 1000 units
The buying or selling of a standard lot would mean that you were placing an order for the value of 100,000 units of the base currency. If we take EUR/USD as an example, we would be placing an order to the value of €100,000, which would in turn give us a pip value of around $10. This is of course a very large amount of money and would mean that we would have gained around $500 in profit in our earlier example. The flip side to this is that a large account balance is required to trade which such large lot sizes.
More common with the retail trader are the mini and micro lot which are worth $1 and $0.1 a pip respectively, dependent upon currency pair and exchange rate.
The benefit of this system is that you are directly responsible for the amount of risk you are prepared to take on per trade. The larger the trade side, you more you stand to lose if the trade goes against you.
Trading Account Leverage & Margin
Leverage enables us to place larger trades and control greater amounts of currencies than would otherwise be possible with smaller account balances. The concept of leverage effectively allows us to borrow money on a short term basis (as long as a trade remains open).
For example, a trading account of $1000 with available leverage of 100:1 would allow that client to open a single standard lot trade for the value of $100,000. In doing so, the Broker would reserve the entire $1000 balance as margin (similar to a deposit). The risk is that if the trade were to move 100 pips in the wrong direction, the Broker would present you with a margin call, closing the trade and keeping the $1000 balance.
A more realistic example would be placing an order for a mini lot, which in this case, would only require $100 to be held in reserve, leaving the other $900 available for further trades.
The general consensus within the industry is that no more than 1-2% of your account balance should be at risk per trade to enable long term account longevity.
Setting Stop Loss & Take Profit
The nature of Forex trading means that orders can remain open for days before the desired price movement is reached. To assist in trade management, we’re able to set a stop loss price to protect us against an unexpected price movement in the wrong direction, effectively closing out the order automatically once our loss parameters have been breached. In the same vain, we can set a take profit price which automatically closes an order once the desired profit level has been reached.