Forex: a long story short

Forex is simply a portmanteau, or mashup, of the words “foreign” and “exchange”; saying it this way (or just as “FX”) may save you as much as half a second. More specifically, forex refers to the market on which traders buy and sell currencies: dollars, pounds, yen, and all the other denominations money comes in.

What do people mean by forex trading?

Forex trading just means exchanging one currency for another, much like you might swap pounds for euros while on holiday. On a larger scale, though, it’s possible to make a profit by buying a currency expected to strengthen using another currency.

If, for example, you expect the value of the yen to rise relative to the dollar, it would be a good idea to buy some yen using the dollars you have. A few days, weeks, or months later, your yen are worth more than your dollars would have been. If you’re familiar with the stock market, you can think of forex trading like day trading, only with currencies instead of shares.

As different currencies are bought and sold through forex trades, each rises or falls in value relative to all the others. These fluctuations are constant, so real-time prices are available and called “currency quotes”. You will have seen these at the bureaux de change selling foreign banknotes at airports. Naturally, forex trading generally happens at a much larger scale.

In fact, the daily trading volume on the worldwide forex market is enormous. The amount of different types of money changing hands, as well as constantly shifting demand for different currencies, creates volatility and provides savvy traders with an opportunity for profit – and, conversely, places them at risk of losing money.

The basics of foreign exchange trading

Unless you’re a bank, importer/exporter, or similar institution, you will most likely conduct your forex trading (FX for short) via an online foreign exchange trading platform like those provided by FxPro and the IG Group. These tools generally offer numerous currencies for sale. 

Since these transactions always involve buying (or selling) one country’s money with (or) for that of another, you will see each exchange rate specified as a numeric ratio signifying the two currencies’ relative value. You will see these numbers everywhere, generally called “currency pairs” or “forex pairs”.

Like publicly traded stocks, each currency has a unique identifying letter code. Using this shorthand, you’re not likely to confuse (say) Australian dollars with American ones. The most actively traded forex pair in the world isEUR/USD, or the price of one euro in dollars. Naturally, EUR stands for euro and USD signifies the US dollar.

Once you’ve joined such a forex trading platform, the process of exchanging one currency for another is quite straightforward. Note the slight difference between the buy and sell prices; this is one way retail trading platforms make a profit from their users’ trades.

Source: FlowBank mobile app

Understanding the difference between base and quote currencies

The first currency in any forex pair is called the “base” currency, while the second is referred to as the “quote” currency. If EUR/USD = 1.35, the euro is the base currency and the U.S. dollar is the quote currency. In this example, one euro is worth 1.35 dollars.

As a forex trader, your goal is to profit by anticipating movements in this number. Simply put, if you bought EUR/USD at 1.35 and sold at 1.36, you’ve made a profit. If you sold at 1.34, however, you’ve lost money.

Which currencies are traded on the open market?

All the world’s major forms of money, as well as lesser-known currencies, can be traded on forex markets. As a rule of thumb, forex traders focus on the currencies of the top 10 largest economies – the dollar or pound is simply more liquid and predictable than, say, the North Korean won. 

Currency pairs are typically split into three major groupings:

1. Major forex pairs

These comprise the US dollar and any of the seven most heavily traded currencies. Examples include the EUR/USD, GBP/USD, USD/CHF, USD/JPY, AUD/USD and CAD/USD (euros, pounds, Swiss francs, yen, Australian and Canadian dollars, respectively).

2. Minor forex pairs

These are typically two major currencies rated against each other but not the US dollar. These are often traded directly, without each first being converted into USD as an intermediate step. This is the case, for example, with EUR/CHF, AUD/NZD and GBP/JPY

3. Exotic forex pairs

Exotic forex pairs consist of one major currency paired with a minor one, such as USD/RUB, GBP/INR, and EUR/PLN. The reason for this bears some explanation:

Smaller or emerging market currencies are typically more volatile than the money used in major economies. In addition, trading them is typically more difficult: on any given day, there may not be many brokers willing to accept Pakistani rupees in exchange for Russian rubles. This means that each of these would first be converted into a more widely respected currency, such as pounds or dollars, adding extra complexity and cost to the transaction.

Eight out of every ten forex trades placed on foreign exchange markets are conducted between the seven major forex pairs. That’s because the U.S. dollar, still the world’s reserve currency, is used to purchase almost every commodity, including gold and oil, that moves across national borders.

Speaking of commodities, we shouldn’t forget that gold and silver are some of the oldest forms of money. It therefore makes sense that these investment options are often available on forex trading platforms. The spot price for gold is quoted using the symbol XAU/USD, while silver is XAG/USD. Some exchanges also handle cryptocurrencies.

FAQs: How To Calculate Profit When Trading Forex

While simple in principle, there’s always a lot more to learn about foreign exchange trading. Even understanding whether or not you’re making money can quickly become confusing when you’re hopping around between different currencies. To get the forex trading ball rolling, let’s take a look at some of the most common questions novice traders have.

What do forex traders mean by “pips”?

Pip is not a synonym for “blip” but short for “Price Interest Point” or, alternatively, “Percentage In Point”. It is the practical unit of measurement for changes in exchange rates. In general conversation, “pip” is used in much the same way as when investors talk about (index) “points”.

Exchange rates are typically quoted in terms of currency ratios, so pips are used to express fluctuations in these. Confusingly, though, there is no standard definition for a pip. As the use of the term increased, it came to be decided that a pip is usually the fourth decimal point when referring to major currencies. For example, if EUR/USD = 1.3002, the pip figure is the 2. However, when discussing currencies with a lower absolute value (like the Japanese yen), the pip is the second decimal point. That is, if USD/JPY was 104.38 and is now 104.42, the movement is 4 pips.

What is meant by “the spread”, as applied to forex trading?

The spread refers to the difference between the buy (“bid”) price and sell (“ask”) price on some currency pair. Like currency price movements, it is measured in pips. It can be thought of as the house’s cut a currency broker charges. With more competition among forex platforms and improved technology, forex spreads are lower than in the past. 

Let’s say that, on some given day, you see:

GBP/USD = bid 1.4035 / ask 1.4037

displayed on your forex trading platform’s dashboard. The spread is then 2 pips (7 – 5 = 2).

Most forex trading platforms will clearly show the spread before a trade is placed and automatically calculate the cost in the currency of your trading account.

How big is a “lot” in forex?

At scale, currencies are traded in blocks known as “lots”. By convention, the lot size in the forex market is normally 100,000 units of the base currency. Forex brokers also offer “mini lots” and even “micro lots” of 10,000 and 1,000 units, respectively.

If EUR/USD = 1.1045, a lot would refer to a transaction of €100,000. Since the buyer pays in American dollars, the cost of the transaction would be $110,045. Of course, few retail investors are willing to risk that much on a single trade. Online forex trading platforms seamlessly repackage currency lots to enable smaller transactions.

How is leverage applied in forex trading?

Few individuals have the ability to make forex investments worth hundreds of thousands of dollars using their own money. However, there is a way to make large trades even with limited available capital by trading on margin, essentially investing money borrowed from your broker. 

Leverage is expressed as the ratio between the size of a position and the cash you deposit to make it happen. 20:1 leverage might therefore mean that you bought $20,000 worth of some currency with only $1,000 of your own money. Note that this tactic increases risk and possible upside in tandem; it should not be used unless you’re pretty certain of what you’re doing and which way the market will jump.

What do forex brokers mean by “margin”?

Your broker’s margin requirement is the amount of funds they want to see in your account before you place a leveraged trade. It can be thought of as a good-faith deposit or collateral against possible losses. If you are offered a leverage ratio of 30:1, then you need $100 in your account to trade $3,000. 

How a forex trade is actually made

Now that we have a handle on pips, spreads, lots, leverage, and margins, it’s time to take a look at how profit is calculated in forex and how orders are executed. An example forex trade should make this clearer:

Let’s say EUR/CHF trades with a bid/ask price of 1.1103 / 1.1106, a 3-pip spread.

You place a trade to “go long” (buy) €20,000 at the ask price of 1.1106

You secure a leverage ratio of 30:1 (i.e. a margin rate of 3.34%)

The margin requirement is therefore (0.34% x 20,000) = 668 EUR (or 741 CHF).

Example of a winning forex trade:

You gauged the market correctly and the price rises to 1.1153 / 1.1156

You close the trade at the bid price of 1.1153.

The difference between your entry and exit is 47 pips.

That means a profit of 47 pips, considering the spread.

What a losing forex trade looks like:

Oh, no, woe is you! The EUR/CHF falls to 1.1053 / 1.1056

You cut your losses at a bid price of 1.1053, implying a loss of 53 pips. Again, this takes the difference between ask and bid prices into account. In both instances, the market moved 50 pips, but the spread of 3 pips is deducted from any profit and added to any loss. Of course, calculating P/L accurately is an essential investing skill; if your broker or trading app should charge any other fees, these need to be taken into account.

How people make money in forex

Finding the best opportunities in forex trading is not a trivial endeavour. Smart traders spend considerable time understanding this market before entering it. First steps include learning to read charts, manage risk, and stay disciplined. Considering how closely the strength of different currencies is tied to economic and political events in the countries that issue them, some understanding of current affairs is also essential. Understanding the mechanics of how to buy and sell currency and trade on margin is not enough!

Even so, the barriers to entry faced by novice forex traders are not insurmountable. Udemy, Coursera, and numerous other online schools offer study programs tailored to beginners. Studying blogs like this one can also give some insight into the best practises of successful traders. In addition, reading books by authors with a proven track record in this field will help sharpen your understanding of forex markets’ subtleties.

In general, there are 7 milestones in learning how to make money trading forex:

• Learn how the forex market works (by reading this far, you’ve made a good start)
• Open a demo trading account (allowing you to practise with imaginary money)
• Get familiar with the trading platform’s interface and functions
• Learn enough technical analysis to be able to read the market price action
• Learn the principles of risk management.
• Develop a trading strategy and backtest the results
• Start trading in a live forex account 

A simple trading strategy for forex market beginners

Trading strategies are as diverse as traders themselves; some are mathematically arcane, while others largely rely on common sense. Let’s take a look at one of the latter, intended to help get you started with understanding price signals and prudent money management. This is mostly aimed at improving your forex trading skills, not paving a path to fortune by itself.

Trend-following forex strategy 

The idea behind this strategy is to trade in the direction of the overall trend in the market, but buying when you see a temporary weakness in the price. In practice, this means tracking patterns within the market, such as the daily average trading volume, and constructing trendlines to get an inkling of what might be coming.

You will follow these steps:

• Find a market that is trending upwards in a 4-hour or daily chart timeframe (H4 or D1)
• Draw a trendline connecting two or more lows (see graph)
• Enter with a market order to buy when the price has bounced more than 20 pips after touching the trendline 
• Set the order as GTC (“Good Til Cancelled”)
• Set a stop-loss 30 pips under the trendline (i.e. a 50-pip stop loss)
• Set a take-profit order of 100 pips (1:2 risk-to-reward ratio)
• Cut your losses if the stop-loss point is reached
• Take your profits if your take-profit order is reached
• If the price drops well below the trendline, cancel the trade
• If the price never reaches the trendline, cancel the trade

The reason all of this sounds somewhat complex…is because it’s not simple. Successful forex trading requires you to keep your eye on the ball and thoroughly understand the rules of the game. However, the rise of online investing platforms supporting foreign exchange trades means that anyone can participate and, potentially, profit handsomely.