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How to Trade Forex?

Read more about what Forex trading is, how to trade Forex and discover a range of tips and strategies.

Forex is the most actively traded market in the world, with around $5 trillion in currency changing hands every day. Of course very little is physically exchanged, with the vast majority of forex trading taking place electronically and speculatively.

Investors have two main ways to trade on forex – spread betting or CFDs. These allow you to speculate on the underlying market price, making profits or losses according to the movement of the price.

Forex is a highly liquid (there are lots of buyers and sellers) market, but it is generally not that volatile. Currencies don’t tend to move much more than 1% in a day. So traders use leverage to control much larger positions than they would be able to if they had to purchase the asset outright. Leverage of up to 200:1 is possible in forex trading, effectively meaning you could control £200,000 of currency with a deposit of £1,000.

Currency Pair - Base v Quote

Currency Pair - Base v Quote

How_to_Trade

The first currency in the pair is known as the base currency. The second is called the quote or counter currency. When buying – going long – you are buying the base currency and selling the quote currency. For example, if you go long on EURUSD, you are buying the euro and notionally selling the dollar. By contrast, selling a pair involves selling the base currency and purchasing the quote/counter currency.

Forex Trading Example with Margin

Forex Trading Example with Margin

Let’s say you have a negative view on the pound versus the dollar and opt to sell sterling. You would do this by going short on GBPUSD.

In our example, the mid-price is 1.4076, and you choose to sell £100,000. The initial margin required to place this trade is £1,000 (100:1). GBPUSD is quoted four places after the decimal point, meaning each ‘pip’ is worth $10.

To reflect the true risk, we must convert this to dollars – 1.4076 x £1,000 = $1,407.60.

The leverage/margin requirement changes in tandem with the fluctuations in the exchange rate.

So, if GBPUSD were to rise to 1.4200, the margin required to maintain this trade would be 1.42 x £1,000 = $1,420.00. By this time, the trade will be losing you $1,240 (124 pips at $10 each), effectively knocking that amount off your margin base. In this scenario, you would only have $180 of margin left.

In this case, you may be required to deposit more funds in your account to cover the trade – what’s called a margin call.

Let’s look at the same base case, selling £100,000 at 1.4076 but this time the pair moves in the direction you hope for.

GBPUSD drops to 1.4000 and you close the trade, delivering a profit of 76 x $10 = $760, or £543 ($760 at the new exchange rate of 1.4000).

In simple terms, you sold £100,000 at 1.4076 = $140,760 and bought it back cheaper at a rate of 1.4000 to swing a £543 profit from just a £1,000 deposit. That’s a profit margin of over 50% on your initial outlay. Without leverage, you’d still have made a profit, but it would only have been £5.43 from your £1,000 stake.

 

how_to_trade_forex_example_with_margins

Rollover

Rollover

Unless you’re trading on currency futures, you will need to think about rollovers. Trading on the spot market – often referred to as simply the rolling daily – is actually a contract to deliver two days in the future. Rather than constantly settling and re-opening positions, forex trading platforms allow traders to rollover positions, effectively resetting the settlement date in the future by another day.

Spot rollover transactions take into account interest rates and interest rate differentials, which are the prime drivers of currency movements. Traders with a long position in a currency with a higher interest rate – ie they are buying that currency – will receive a few pips on this spot rollover. If you were short, you would be debited the same amount of pips.

This interest rate differential is the basis of the ‘carry trade’ – a forex trading strategy has periodically found favour among investors depending on market conditions.

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