Trading Mechanism

How much money is required for Forex trading? In order to find out, it is necessary to study the mechanisms of making a deal.

First, when a trader buys a currency, he doesn’t buy Euros or British pounds, he buys a currency pair, e.g. euro-dollar (written like this: EURUSD). This means that we are buying Euros for dollars. The currency which is written first is called theBase currency; the currency which is written second is called the Quote currency. And a trader doesn’t buy the amount directly; the forex trading is done by lots. One lot represents 100,000 units of a base currency. In other words, in our previous example, we are buying 100,000 Euros on Forex trading market. How many dollars should we be paying for it? There is a notion of “currency pair exchange rate” which is a monetary denomination of the cost of a currency pair, to be more exact, a unit of base currency expressed in quote currency. And when we say that a euro/dollar costs 1.3875, it actually means that for 1 euro we may get 1 dollar and almost 39 cents. To buy one full lot of such a currency pair we need to pay 100,000 * 1.3875 = $ 138,750 on Forex trading market. Obviously, very few people have this kind of money. And this is why traders have lately been working on a marginal basis.

A margin is a deposit. When a bank opens a position for a trader, the bank is actually paying for the entire lot, and the trader gives the bank a deposit 100 times lower, i.e. “the leverage” mechanism is applied. Usually the leverage is 1:100 on forex trading market. Accordingly, the Forex trading deposit in this example will be $ 1,387.50. When a forex trading position is closed, the deposit is returned to the trader in full, regardless of the result. Because of this, in order for a trader to make a deal, he needs a certain sum of money for a forex trading deposit, and his account should have some extra money as a so-called “safety net”. Usually, the deposit sum for various currency pairs is shown in the Contract Specification Table. For example, in forex trading for the currency pair British pound/dollar (denominated as GBPUSD) to make a deal in 1 lot with the leverage 1:100, the deposit will be 1,000 GBP which is about $ 2,000, and for the currency pair New Zealand dollar/US dollar (denominated as NZDUSD), 1,000 NZD, i.e. about $ 600. For all other currency pairs the deposit will be almost the same, i.e. the deposit will almost never exceed $ 2,000.

The minimum sum required to trade in one lot should be about $ 2,000-2,500, and the greater the sum, the more relaxed and safe the forex trading is. No matter what, before opening a forex trading position, the trader should first analyse the market to find a profitable situation where money can be earned.

When speaking about the principle of profit, we have mentioned the importance of the leverage in Forex trading, in particular, for private traders with relatively small capital. We have given an example of how the leverage works. By using the leverage, a relatively small amount of money on the forex trading accounts can be used for trading a sum 50-500 times higher.

Now let’s take a better look at how this mechanism really works.

For example, imagine that you have 100 US dollars in your forex trading account. In order to simplify the calculation, let’s assume that the leverage is 1:100. Let’s assume that you believe that the Japanese yen will grow in the near future and you decide to buy a maximum amount of this currency on the Forex. Since your deposit represents 100 dollars and the leverage is 1:100, you can operate with a sum of 10,000 dollars (100 dollars * 100 = 10,000 dollars). Your dealer, or more accurately the partner bank of your dealer, will issue you an interest-free target credit for the purchase of the said currency. Obviously, this money can only be spent on the Forex trading deal. To get such a credit, you have to fill out many forms, gather certificates, look for credit guarantors, and wait for a few weeks just like when you apply for a bank loan. This credit is issued “on the fly”, i.e. at the moment of making the deal. Thus, the bank adds 9,900 dollars to your 100 dollars, and, as a result, you have a sum 100 times greater.

With this sum you decide to buy some Japanese yen. Let’s say the rate is 1 to 120 (120 Japanese yen for 1 US dollar). Thus, you buy 120 * 10,000 = 1,200,000 Japanese yen. Assume, that your forecast about the growth of Japanese yen to the dollar does come true, and some time later (maybe, in a few minutes or in several months) the rate of the yen drops by 1 to 119. Do not worry by the figure going down from 120 to 119: the yen has really grown, because for 1 dollar you now have to pay fewer yen. We can also say that the “dollar has dropped to the Japanese yen” and the lower figure will make sense. Now you sell 1,200,000 Japanese yen and get 1,200,000: 119 = 10,084.03 dollars. After this, the bank takes away its9,900 dollars (don’t forget that the bank loaned them expecting a fast reimbursement of the debt) and you now have 10,084.03 – 9,900 = 184.03 dollars. Your forex trading profit is 84.03 dollars. Great!

Now let’s consider a less favorable situation, wherein your forecast turns sour and the yen rate drops to 121.21. In such a case, the situation is rather unpleasant: if you sell your 1,200,000 yen at the current rate you will make 1,200,000: 121.21 =9900.17 dollars. When the rate drops by an additional point and reaches 121.22, then, 1,200,000 yen will bring you only 1,200,000: 121.22 = 9899.36 dollars. This is less than the sum which you owe the bank, and it is evident that in such a situation, the dealer will have to forcefully close the deal at the current rate and return the bank its 9,900 dollars, and you will be left with only 17 cents. Such a situation is called “margin call”. In this situation the trader actually loses all his capital (in our example only 17 cents will be left from 100 dollars). To avoid such situations you need to learn to calculate possible losses in advance and close loss-making positions at the right time, using defensive stop orders.

Dealers in most companies work mainly in US dollars, and very rarely in any other world leading or national currency. It is essential to understand one very important thing: if your forex trading account is in dollars, it doesn’t mean that you can only make deals when a currency is being bought for dollars. It may seem paradoxical, but you may buy dollars for some other currency which you, naturally, don’t have in your dollar forex trading account. For example, you may buy dollars for Euros. Such deals are made when the euro rate is expected to fall to the dollar and is called “buy dollar against euro”. You may even make a deal where the dollar is not present at all, e.g. buy Japanese yen against Swiss francs. Your forex trading account is debited in dollars in an amount equivalent to the cost of the deal, and the currency is automatically converted at the current exchange rate.

• US dollar – USD;

• Euro – EUR;

• British pound of sterling– GBP;

• Japanese yen– JPY;

• Swiss franc – CHF.

These currencies are the most popular for Forex trading market. We have already stated that when the trader buys a currency, he does not buy Euros or British pounds, but a currency pair, e.g. euro-dollar (EURUSD), which means that he buys Euros for dollars. In this example, the euro is the base currency and the dollar is the quote currency. We say “buy euro-dollar”, “sell euro-dollar”. The most popular currency pairs are in forex trading: EURUSD, GBPUSD, USDCHF and USDJPY.

Making a deal on the Forex trading market is usually called, “opening a position”. Subsequently, instead of saying, “I’m buying Euros” one should say, “I’m opening a position in Euros”. If the other currency is not identified, it means that it’s a euro-dollar currency pair (EURUSD), i.e. Euros are bought for US dollars. Depending on whether you are buying or selling, the positions are called “long” (“bull”) or “short” (“bear”) on the Forex trading market. So in our case, we should say, “I’m opening a long position in Euros”.

Here is an example of how Forex trading works. Let’s assume that the euro will grow in value, i.e. the price will go up and we open a long position – buy Euros. If we expect the euro to fall to the dollar, we sell the euro, i.e. open a short position. With regard to Forex trading in currencies for which the base currency is the US dollar, e.g. in a pair dollar-Swiss franc (USDCHF), the situation is a little different. If we believe that the Swiss franc will grow to the US dollar, then the price will go down as opposed in the situation with the euro. In this case, we open a short position for the USDCHF currency pair. Remember the rule that applies to any currency pair: if we expect the price to go up – we buy (open a long position), if we expect the price to go down – we sell (open a short position) on the Forex trading market.

Along with the concept of opening a position, there is the opposite concept on the Forex trading, “closing a position”. It means making a deal opposite to the deal we made when opening the position. If earlier we bought Euros for dollars, now we sell Euros for dollars; if we sold British pounds for Swiss francs, now we buy them for Swiss francs. Proceeds from the deal will hit our account, with gains flowing into our account and losses flowing out.

There is another way to monetarily express a currency pair, besides the rate of a currency pair: a quote. This is the information on the current rate of a currency pair expressed in two figures – Bid and Ask.

The difference between bid and ask is called the bid-ask spread. The spreads in the Forex trading market are very small. For most currency pairs, the spread is from 2 to 4 points, which is much smaller even than spreads of the better performing, liquid securities on other markets. Spread is a hidden, “integral” cost of the forex trading, and it is minimal for the currency market. New technologies have made these low prices available to just about everybody.

Point (Pip – price interest point) is the minimum price fluctuation in the cost of a currency pair. For the majority of currencies the currency rate is calculated up to a fourth of a decimal figure. Thus, 1 point is 1/10 000 or 0.0001 of the quote currency. Change in 1 point for GPB/USD at 1.7519 leads to a price of 1.7520. The point value for some currency rates, such as USD/JPY, is calculated only up to the second decimal figure (i.e. 1/100 or 0.01).

The majority of Forex trading platforms automatically calculate the trader’s profit and loss for open positions. This helps the trader to track profit and loss simultaneously as the market prices constantly change. However, the trader should know how such calculations are made.

Sell 5 lots EUR/USD at price 1.4625 and buy them at price 1.4570:

In this example the client gets 55 points х 5 lots = 275 points of overall profit (as the trader sells them at a higher price than he bought them). The cost of every point for pair EUR/USD is $ 10. Thus, the final profit is 275 points x $ 10 = $ 2,750 in forex trading.

Buy 3 lots USD/JPY at price 102.10 and sell them at price 101.80:

In this example the client gets 30 points х 3 lots = 90 points of overall losses (as the client sells at a lower price than he bought them). The cost of every point for pair USD/JPY is 1000 JPY which in dollars represents 1,000: 101.80 (USD/JPY rate at the time of position closing) = about $9.82. Thus, the final loss of the client is 90 points x $9.82 = $883.80 in forex trading.

Sell 2 lots EUR/GBP at price 0.8154 and buy them at price 0.7802:

In this example the client gets 352 points х 2 lots = 704 points of overall profit. The cost of every point for pair EUR/GBP is 10 GBP which in dollars is 10 x 1.73 (let’s assume that GBP/USD rate at the time of position closing is 1.7300) = $ 17.30. Thus, the final profit is 704 points x $ 17.30 = $12,179.20 in forex trading.