How to Trade Currencies

How to trade currencies

When you trade Forex, you are effectively buying or selling one particular currency for the other. If you decide to buy a currency pair, you will be hoping that the base currency will appreciate against its counterpart. The opposite will be true if you sell a currency pair.

How to place a trade

All currency pairs are quoted in two prices – the buying (or ask) price and the selling (or bid) price. The difference between these two values is known as the “price”, and signifies how much a broker will charge to open the position.

Quotes are usually displayed up to four decimal places, for example, 1.2345. If we say that the EUR/GBP price is 1.2345, a trader will need to invest 1.2345 GBP for each EUR they wish to buy.

Any change in a currency’s value will usually be seen in the fourth decimal place, or “pip”. The spreads, gains and losses of each trade are therefore displayed as pips.

For example, if a trader opens a buying position for EUR/GBP at a quote of 1.2345, and closes their position at 1.2347, they have made a profit equivalent to two pips.

In order to place a trade, first of all check the ask and bid prices, then decide whether you wish to buy or sell the pair. You will then choose the number of units you wish to trade.

Understanding leverage

Leverage can be a useful tool for traders, as it allows them to open larger positions than their initial investment would otherwise allow. For example, if a trader wanted to control a position of $100,000, they would need to invest of the capital themselves if they just used a leverage of 1:1.

Alternatively, a trader can use leverage to only invest a small amount of their own capital into a position, and effectively borrow the rest from the broker. For example, if they open a $100,000 position using a leverage of 1:100, they would only need to put in $1,000 of their own money.

Traders use leverage to make their capital go further, and also potentially increase the size of their profit. However, it is important to remember that it can also magnify any losses if the markets move a different way to how you predicted. As a result, you should always use leverage wisely and never invest more than what you can afford to lose.

To illustrate how effective leverage can be, let us assume that the $100,000 trading position mentioned above made a profit of $1,000. If the trader was only using a leverage of 1:1 the profit they would take would only be 1% (a $1,000 gain from a $100,000 investment). However, a leverage of 1:100 would yield a profit of 100% (a $1,000 gain from a $1,000 initial payment).

Of course, leverage can work both ways. If the $100,000 trading position makes a loss of $1,000, the trader would only make a loss of 1% if they used a leverage of 1:1. However, they would stand to make a loss of 100% if they used a leverage of 1:100.

What is margin?

A margin is defined as the amount of money the trader must invest in order to open a position. If we use the $100,000 example above, then the margin would either be $100,000 using a 1:1 leverage, or $1,000 with a ratio of 1:100.

To calculate the amount of margin needed to place a trade, simply divide the deal amount by the leverage (for example 100,000 / 100 = 1,000). Margins are always expressed as a percentage.

Used & free margins

Put simply, a used margin is the amount of money that a trader has tied up in their open positions. For example, if they had opened a $100,000 position with a $1,000 investment, the $1,000 would be the used margin – assuming this is the only position they had open at the time.

A free margin is any funds that are left over in the trading account that are not tied up in open positions. If we assume that a trader deposited $10,000 in their trading account and opened a position in which they invested $1,000 as a margin, the free margin left in the account would be $9,000.

Provided this position does not stray into negative territory, the trader would be able to invest the full $9,000 in new trades.

Margin calls

A margin call is effectively a request from a broker for a trader to deposit more funds, so that their existing positions can remain open. It occurs when the available equity in a trading account drops below the maintenance margin (the minimum amount that a trader must have available in order to keep their positions open). In some cases, the broker may close open positions so that the equity balance meets the margin requirement.

Traders can protect themselves from a margin call using a number of methods, including the implementation of stop loss orders, which will reduce their exposure to risk. Another option would be to use a low ratio of leverage, so that you are still improving your profit potential, without becoming too exposed if the market becomes volatile.   

Bulls and bears

Throughout your trading journey, the two phrases you will likely hear a lot are bulls and bears. These terms are commonly used to describe market fluctuations, or even investors themselves.

A bull market is where an asset is on an upward trajectory, while a bear market signifies a trajectory in the opposite direction. When it comes to traders, a bull is said to be someone who is aggressive and likes to attack the market, while a bear tends to be more defensive and pessimistic.

The actual origin of these terms is unclear, although a popular theory is thought to derive from how each animal attacks its opponents. Bulls tend to thrust their horns up in the air, while bears will swipe downwards.

Currency pair classifications

There are three categories of currency pairs – majors, minors and exotics.

Major pairs always include the USD, no matter if it is the base or counter currency. Examples include USD/JPY, GBP/USD and USD/CHF.

The minor pairs occur when the major currencies are traded against each other, but the USD is not included. Examples of this include GBP/EUR, AUD/CAD and CHF/NZD.

Exotic pairs involve one major currency and one minor currency, such as CHF/TRY and GBP/NOK.