How Does A Forex Trade Work?

For the Forex currency trading beginner a trade can be a little confusing until you break it down and come to grips with some of the trading terminology.

The purpose of any Forex trade is to swap one currency for another in the belief that the market will move and prices change such that the currency that you buy rises in value in relation to the currency which you sell.

The first important point is that each trade involves two currencies – the currency which you buy and the currency you sell. This gives us our first two important trading terms – the long position and the short position.

You take a long position when you buy a currency in the belief that it will rise in value and that you will able to sell at a profit.

If you sell a currency in the belief that it will fall in value you take a short position and hope to make a profit by buying it back again once the price has fallen.

The next important concept is that of the open and closed position. When you take a long position and buy a currency in the expectation that it will rise in value you open a position. When you later sell that currency to take you profit you close the position. The same is true when you take a short position and open that position by selling a currency in the expectation that it will fall in price and later close the position when you buy the currency back at the lower price.

Note: How does day trading work? You will often hear the term ‘day trading’ used and this confuses a lot of newcomers to the world of investing. When applied to forex trading, day trading simply means short-term trading effected by opening and closing trading positions within the same trading day, rather than running a trade over an extended period of time.

In Forex trading currencies are referred to by codes (developed by the International Organization for Standardization and known as ISO codes) such as USD for the US Dollar and GBP for the UK Pound. Prices for these currencies are quoted as either USD/GBP or GBP/USD with the first currency appearing in the quote being the base currency and the second currency being the counter or quote currency.

Here’s an example quote to make things a bit easier to understand:

USD/GBP = 0.5260

In this case the US Dollar is the base currency and the UK Pound is the counter or quote currency. The base currency is always read as a single unit and so this quote means that it will cost 0.5260 UK Pounds to buy 1 US Dollar. Here’s another quote:

GBP/USD = 1.9150

In this case it will cost 1.9150 US Dollars to buy 1 UK Pound.

In real world trading it’s a bit more complicated as the market maker needs to add in his profit for selling you a currency or for buying currency from you. In reality therefore a quote might look more like this:

GBP/USD = 1.9238 1.9243

In this case the first figure is the ’sell’ or ‘ask’ figure and the second is the ‘buy’ or ‘bid’ figure. The first figure is price at which a trader will sell the currency pair and the second is the price at which he will buy the pair. The difference between the two prices is known as the spread.

Prices are normally quoted to four decimal places and the fourth decimal place, which represents the smallest amount by which one currency can move against the other, is known as a ‘pip’. In this case therefore the spread is 5 pips.

In our example therefore, if you wish to sell UK Pounds, the market maker will buy them from you at 1.9243 US Dollars per UK Pound and, if you wish to buy UK Pounds, 1 UK Pound will cost you 1.9238 US Dollars.

If you are just starting to learn Forex currency trading then this probably seems a little bit complicated but it represents the basis on which the Forex market operates and will quickly become second nature.

How Does A Forex Trade Work?

For the Forex currency trading beginner a trade can be a little confusing until you break it down and come to grips with some of the trading terminology.

The purpose of any Forex trade is to swap one currency for another in the belief that the market will move and prices change such that the currency that you buy rises in value in relation to the currency which you sell.

The first important point is that each trade involves two currencies – the currency which you buy and the currency you sell. This gives us our first two important trading terms – the long position and the short position.

You take a long position when you buy a currency in the belief that it will rise in value and that you will able to sell at a profit.

If you sell a currency in the belief that it will fall in value you take a short position and hope to make a profit by buying it back again once the price has fallen.

The next important concept is that of the open and closed position. When you take a long position and buy a currency in the expectation that it will rise in value you open a position. When you later sell that currency to take you profit you close the position. The same is true when you take a short position and open that position by selling a currency in the expectation that it will fall in price and later close the position when you buy the currency back at the lower price.

Note: How does day trading work? You will often hear the term ‘day trading’ used and this confuses a lot of newcomers to the world of investing. When applied to forex trading, day trading simply means short-term trading effected by opening and closing trading positions within the same trading day, rather than running a trade over an extended period of time.

In Forex trading currencies are referred to by codes (developed by the International Organization for Standardization and known as ISO codes) such as USD for the US Dollar and GBP for the UK Pound. Prices for these currencies are quoted as either USD/GBP or GBP/USD with the first currency appearing in the quote being the base currency and the second currency being the counter or quote currency.

Here’s an example quote to make things a bit easier to understand:

USD/GBP = 0.5260

In this case the US Dollar is the base currency and the UK Pound is the counter or quote currency. The base currency is always read as a single unit and so this quote means that it will cost 0.5260 UK Pounds to buy 1 US Dollar. Here’s another quote:

GBP/USD = 1.9150

In this case it will cost 1.9150 US Dollars to buy 1 UK Pound.

In real world trading it’s a bit more complicated as the market maker needs to add in his profit for selling you a currency or for buying currency from you. In reality therefore a quote might look more like this:

GBP/USD = 1.9238 1.9243

In this case the first figure is the ’sell’ or ‘ask’ figure and the second is the ‘buy’ or ‘bid’ figure. The first figure is price at which a trader will sell the currency pair and the second is the price at which he will buy the pair. The difference between the two prices is known as the spread.

Prices are normally quoted to four decimal places and the fourth decimal place, which represents the smallest amount by which one currency can move against the other, is known as a ‘pip’. In this case therefore the spread is 5 pips.

In our example therefore, if you wish to sell UK Pounds, the market maker will buy them from you at 1.9243 US Dollars per UK Pound and, if you wish to buy UK Pounds, 1 UK Pound will cost you 1.9238 US Dollars.

If you are just starting to learn Forex currency trading then this probably seems a little bit complicated but it represents the basis on which the Forex market operates and will quickly become second nature.

The Forex Demo Account

As a novice you will probably begin trading by opening a Forex demo account and your first few trades will be paper trades, or simulated Forex trading, as you learn how the market works and how to use some of the trading tools. It is not long however before you are ready to move on and to put your paper trading days behind you. But is it such a good idea to leave paper trading behind you?

Many successful Forex traders today are discovering that continuing to trade on paper from time to time can be both helpful and profitable.
Problems often arise for traders when they find themselves with a losing trade. Despite the fact that losing trades are an everyday part of trading life, you are always going to be affected by a trading loss and there is often a strong, albeit often subconscious, urge to recoup the money you have just lost as fast as possible. This frequently means that you go right back into the market but, because you are in a losing frame of mind, your next trade often also results in a loss or a less than spectacular gain.
For many traders the answer to this problem is to follow a losing trade with a paper trade.
In this case you trade seriously and in exactly the same way that you would trade normally but run the trade on paper. You study the market indicators, open a trading position, put a stop loss order in place and then track the trade. As the trade progresses you move your stop loss order as the market moves and, finally, you close out your position when your market indicators tell you to do so.
This paper trade might result in a profit or a loss but, as the trade is only being made on paper, it doesn’t matter one way or the other. The importance of this trade is that it allows you to clear your mind and to put your previous losing trade behind you. Even if this paper trade results in a loss the affect is positive because you are happy knowing that you have not actually lost any money.

Having run this paper trade you are now ready to leave the world of simulated Forex trading and return to live trading and can open a new trading position in a winning frame of mind.

Trading In A Market Which Is Always On The Move

The Forex market never stands still and even though it may move quite slowly at times it is nevertheless always on the move. It is of curse this movement which provides the opportunity to make money buying and selling global currencies, but it can also make it difficult to decide when to open a trade, close a trade or simply stay out of the market altogether.

Probably the greatest problem with the fast moving foreign currency market however is that it plays on our natural sense of greed and this can present traders with a very real danger.

We all like to make a profit, but what level of profit is acceptable? If you are in a trade which is showing a profit of $2,000 should you close your position and take your profit or hang on in there for $2,500? You are trading to make money and so, when the market is moving in your favor, it is only natural to want to ride the wave all the way to the beach. The difficulty however often lies in knowing when you have hit the beach and in not waiting for the undertow to start dragging you back out to sea again. Once the undertow catches you it can drag you back out to sea again very quickly.

Most Forex traders enter foreign currency trading with a clear picture in their mind’s eye of just what they intend to do with all the money they are going to make and that is no bad thing. It is extremely important for you to have a goal, as well as a plan of action to allow you to reach that goal, and it certainly helps if you create a visual image in your mind of something concrete you are aiming for.

The problem however is that you could well find that you are tempted to try to reach your goal sooner than you had planned or that you create a bigger and better goal as you go along, allowing your natural tendency towards greed creep in and to start taking control of your trading.

Another commonly seen problem is that of failing to understand that it is not money which drives the market.

Think about this for a minute. It doesn’t matter if you have $10,000 or $100,000 in your trading account because whatever sum you’re looking at it is not going to make the slightest difference to the way in which the market moves. By the same token, it doesn’t matter if you are looking at a $750 profit or a $750 loss in an open trading position because this again will not make any difference at all as far as the market rising or falling is concerned.

The fact that you are doing well in a trade and have made a profit of $750 does not mean that this profit will turn into $900 or $1,000 if you wait a bit longer. It is of course human nature to find yourself caught up in your ‘winning streak’ and to convince yourself that there is more profit to come.

It is also human nature to find that, having already lost $750 in an open trade, you will try to convince yourself that things will turn around if you keep your nerve and just hold on a little longer.

It is essential that you set a goal and have a plan to reach that goal but your trading decisions must be based on what is happening in the market and not on your goal.

Money should have no influence on whether or not you enter or exit a trade, or stay out of the market altogether, and these decisions should be based solely on what your analysis of the market tell you.