Forex (FX, Currency Exchange, Foreign Currency) is by far the most highly traded and liquid market in the world with daily transaction volumes well above USD 4 Trillion. Characterized as an OTC market (Over The Counter) there is no centrally regulated exchange, and the marketplace is made up of various groups including Retail and Institutional Investors, Broker, Liquidity Providers, Banks and Hedge Funds.
The basic trade consists of the relative movement of the exchange rate between two currencies. Trades are taken in pairs, for example, the EURUSD (Euro vs. United States Dollar). Price quotes are displayed as the exchange rate for these two currencies. For example, you might see a price displayed as:
EURUSD – 1.05000
The indicates that 1 EUR is worth 1.05000 USD. EuropeFX is a 5-digit broker, so all prices are quoted to the 5th digit, allowing for fractional pricing and tighter spreads.
In our EURUSD example, the first currency (EUR) in the pair is known as the Base Currency. The second currency in the pair (USD) is known as the Quote Currency.
Forex currencies are traded in what we term Lots. A Standard Lot is equivalent to 100,000 units of the base currency and the equivalent amount in the quote currency.
Sticking to our EURUSD example with the pricing at 1.05000, a Standard Lot would be the exchange of 100,000 EUR for 105,000 USD. Trades can be made in fractions of standard lots. For example Mini Lots which are equal to 1/10th of a standard lot or 10,000 units of the base currency and even Micro Lots which are equal to 1/100th of a standard lot or 1,000 units of the base currency.
- A Standard Lot = 100,000 units of base currency
- A Mini Lot = 10,000 units of base currency
- A Micro Lot = 1,000 units of base currency
Profits on forex trades are realized on what is referred to as the Round Trip, that is opening a trade in one direction then closing it in the other direction, the direction, in this case, being either BUY (Long) or SELL (Short).
Let’s illustrate this with a continuation of our EURUSD example. As we’ve saw the price for the pair was 1.05000.
If we believe the EUR will appreciate in value against the USD, we will enter a BUY trade. If we BUY 1 Lot of EURUSD we now “own” 100,000 EUR and “owe” the market 105,000 USD.
Our Buy prediction was accurate, and the EUR increases in value and the rate is now 1.07000.
To close the trade, we would sell our 100,000 EUR for 107,000 USD, which would cover the amount we “owe” the market for a profit on the trade of 2,000 USD.
Conversely, if we believed the EUR would depreciate against the USD, we would SELL 1 lot of EUR at the 1.05000 price, resulting in us “owing” the market 100,000 EUR but “owning” 105,000 USD.
Again our prediction was correct, and the EUR does indeed depreciate against the USD, falling to 1.03000.
Our 105,000 USD are now worth 101,941 EUR (105,000/1.03000), giving us a profit on the trade of 1,941 EUR.
Forex trading is a leveraged product. That is to say; your broker will essentially “lend” you a multiple of the amount deposited in your trading account. For example, 1:30 Leverage means that for every $1 deposited in your trading account, your broker “lends” you $30. Deposit $10,000 in your trading account and with the 1:30 leverage you would effectively be able to open $300,000 worth of trades.
While leverage can serve to multiply trading results, judicious use is always advised as leverage can also multiply losses.