The Mechanics of Trading

The forex market allows you to buy and sell currencies against each other, and to speculate on the differences in exchange rates.

You make a profit when the currency you bought increases in value compared to the one you sold.

Here is an example:

You bought 100,000 EUR/USD at 1.2500.
This would cost you US$125,000 (EUR 100,000 x 1.2500)

A day later the EUR/USD rate has risen to 1.2575. You therefore want to take your profit.
You exchange your 100,000 euros back into US dollars at the exchange rate of 1.2575.

You get 125,750 US dollars (100,000 x 1.2575)

Therefore, you make a profit of US$750 (125,750 - 125,000)

How to Read an FX Quote
Here is an example of an FX quote.

Currencies are quoted in pairs, for example - EUR/USD. They are quoted in pairs because in every foreign exchange transaction you are simultaneously buying one currency and selling another. The first currency in the pair is called the base currency (in this example, the Euro). The second is called the counter (or quote) currency (in this example, the U.S. dollar).

The base currency is the 'basis' for purchases and sales. When you buy, you buy the base currency. When you sell, you sell the base currency.

For example, if you buy EUR/USD, you acquire Euros and sell Dollars. You do this if you expect the Euro to grow against the Dollar.

Each transaction must have two sides - a buy and a sell (or a sell and a buy). By this we mean that it is impossible to buy 100,000 EUR/USD and then exchange it for another currency pair (e.g. EUR/JPY) without closing the first position.

When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy one unit of the base currency.

For example: EUR/US$= 1.1702.

In this example, you have to pay 1.1702 U.S. dollars to buy 1 Euro.

When selling, the exchange rate tells you how many units of the quote currency you get for selling one unit of the base currency. In the example above, you will receive 1.1702 U.S. dollars when you sell 1 Euro.

You buy the pair when you believe the base currency will appreciate (increase) relative to the quote currency. You sell the pair when you think the base currency will depreciate (decrease) relative to the quote currency.

You should know by now that no physical currency delivery is made.

Long/Short You buy (i.e. buy the base currency and sell the quote currency) when you expect the base currency to rise in value. This is called "going long" or taking a 'long position'. 'Long' means buy.

You sell (i.e. sell the base currency and buy the quote currency) when you expect the base currency to fall in value. This is called "going short" or taking a 'short position'. 'Short' means sell.

Bid/Ask Spread
As with any market, for each currency pair there are 2 prices. The bid and ask. The bid (sell) price is always lower than the ask (buy) price.

The bid is the price at which the dealer is willing to buy the base currency in exchange for the quote currency. This means the bid is the price at which you (as the trader) will sell.

The 'ask' is the price at which the dealer will sell the base currency in exchange for the quote currency. This means the 'ask' is the price at which you will buy.

The difference between the bid and the ask price is called the spread.

Here again is the example of a price quote taken from ACM's trading platform (they do not use the terms bid and ask, simply buy and sell).

The spread is measured in pips. This is the lowest decimal figure in a currency rate. In this example, the spread is 1 pip (1.1701 - 1.1702).

If you want to sell Euro, you click 'Sell EUR' and you will sell at 1.1701.

If you want to buy Euro, you click 'Buy EUR', and you will buy at 1.1702.

Either action will immediately open a position in the market. Your trade will immediately appear on your trading station showing a profit or loss.

Margin Margin trading refers to trading with borrowed capital. It increases buying power, letting you conduct relatively large transactions, very quickly and cheaply, with little initial capital.

Some brokers offer a 1% margin (or 1:100 leverage). This means you can trade up to 100 times your deposit. For example, US$5,000 initial investment entitles you to trade up to US$500,000.

Margin trading in the foreign exchange market is quantified in "lots". A lot is the minimum amount of currency you have to buy. At the supermarket, for example, you can't buy one egg. You have to buy at minimum a dozen. The dozen is, in effect, a lot. Forex trading is conducted in lots of $10,000 or $100,000 depending on the broker and the types of accounts they provide.

Example: You open a forex account with US$1,000. Your broker offers a 1% margin. This means you can trade up to a maximum of US$100,000 (i.e. 1,000 x 100).

You believe the euro will go up against the US Dollar. The current price for EUR/USD is 1.4000. So you decide to buy 1 lot ($100,000) of euros.

The price of EUR/USD goes up as expected so you want to take your profit. You have to sell back the euros to take your profit. The price is now 1.4050. So you make a profit of US$500 ((1.4050 - 1.4000) x100000)). The profit is computed automatically on your broker's platform. The broker instantly credits your account with your $500 profit. Your account has grown to $1,500.

With an initial investment of US$1,000 you made a profit of US$500. This is a 50% return (500/1000)! This illustrates the power of trading with margin.

Rollover When you hold a position (a trade) overnight, the position is said to be 'rolled over'. When your position is rolled over you may pay or receive a rollover fee.

The rollover fee is based on the difference in the interest rates that apply to the two currencies in the pair that you're trading.

If you buy a currency pair where the base currency has a higher interest rate than the quote currency, then you'll receive interest, and vice versa.

For example, if you buy the AUD/USD, and the interbank interest rates are higher in Australia than in the US, then you may receive a rollover fee. On the other hand, if the interest rates are higher in the US, then you may have to pay a rollover fee. Usually the rollover fee is a relatively small amount, compared to the profits and losses of a system.

To avoid interest payments on your positions, you have to close all positions before 5pm EST, the established end of the market day.

Demo Trading Most Forex brokers offer a free demo account to help you learn forex trading.

A demo account has the full capabilities of a 'real' account. It is not a simulation of market conditions, rather, it reflects actual market conditions. But you trade 'virtual' money, not real money. There is no risk.

Demo trading allows you to learn the ins and outs of your broker's trading platform, learn the market, and test your trading skills and strategy before risking a cent.

There is no better way to get comfortable with placing buy and sell orders, stop and limit orders, etc. You have to be completely proficient in the use of your broker's platform before you begin to trade live.

We highly recommend that you demo trade for at least a month before risking your money.