HOW TO TRADE FOREX? FOREX SPREAD AND HIGH LEVERAGE EXPLANATION
Now, when we know what is traded in the Forex market, we need to understand major mechanism of trading and get the idea of what Forex spread and high leverage are.
Transactions made in the Forex market are called positions. There are two types of positions:
BUY means buying a financial instrument while expecting rise in quotation;
SELL means a position held with expectation that asset will fall in value.
Let's remind that "Buy" position is also called a "long position", as it is noted, that the value of the exchange rate usually increases long and slowly. Opposite, "Sell" is called a "short position", as the value of the exchange rate often decreases very fast.
- Suppose a trader predicts U.S. dollar is getting weaker against Euro, then he sends BUY EUR/USD order (purchase Euros);
- If a trader assumes Euro is getting weaker against the U.S. dollar, SELL EUR/USD order should be sent (sell Euros).
The facts above can be applied to all currency pairs. Thus, a trader can earn on both growth and drop of exchange rates.
The exchange rate submitted by seller or buyer is called currency quotation. There are two quotations for each currency pair:
Ask (Offer) means the higher price in quotation; price at which trader can buy;
Bid (Last) means the lower price in the quotation; the price at which trader can sell.
Take a look at a typical representation of quotations:
As we see, EUR/USD = 1.22471/511 (which means Bid/Ask ratio). It means that a trader can buy Euro for the U.S. dollars at Ask price = 1.22471 or can sell Euro for the U.S. dollar at Bid price = 1.22511
Please note that sale price (Bid) is always less than buy price (Ask). The difference between buy and sell is called Forex spread. Spread is a traditional commission for a trading operation in any financial market, it is more familiar to us from currency exchanges. Spread may be fixed (permanent) and floating (vary over time). Forex spread usually depends on liquidity of a currency pair (trading activity) and terms of a broker. In general, at any time, spread can be expressed in the following form:
Forex Spread = Ask – Bid
In this case, spread is: 1.22471-1.22511 = 4 points. Point or pip is a minimal change of the exchange rate. Thus, change in quote in one point for currency pair EUR/USD is equal to change in the last fourth number after decimal point. For example, changing from 1.2401 to 1.2402 or 1.2485 to 1.2486, etc. Changing in quote in 100 points is called a big figure.
Traditionally, almost in all currency pairs (EUR/USD, GBP/USD, USD/CHF etc.) one point is 1/10,000 ie 0.0001, and only for USD/JPY and cross rates that involve the Japanese yen - one point is 1/100 ie 0.01. But today many brokers tend to exact quotation, so do not be surprised if you see such quotes as 1.24849 for EUR/USD or 89,948 for USD/JPY. Of course, in this case one point will be equal to 0.00001 and 0.001 part of quote.
It is obvious, to buy something you need an exact amount of money. The same thing with the Forex market. When you conduct a trading operation, you must determine its volume. But the contract volume is specified in standard units of measurement – lots. It is accepted on the Forex market that:
1 lot equals to 100 000 of base currency
Let's remind that base currency is one that comes first in currency pair. So, when a trader opens 1 lot of euro/US dollar (EUR/USD), then volume of this contract is 100 000 euros, but if a trader opens 1 lot of US dollar/franc (USD/CHF), then volume of this contract will be 100 000 U.S. dollars. It is not necessary to start trading with such considerable sums of money. Volume of a transaction can be expressed in an incomplete (fractional) lot, for example
0.05 of lot amounts to 5 000 of base currency,
0.2 of lot amounts to 20 000 of base currency,
2.3 of lot amounts to 230 000 of base currency,
5 of lot amounts to 500 000 of base currency etc.
It is very important to understand that volume of the contract determines it's potential profit or possible losses in particular transaction(s), because it defines cost of one point when quotation changes. Originally,cost of point is always expressed in quoted currency (the one that takes second place in the currency pair). Let's look at the calculation:
cost of point in quoted currency = Lot * fraction of point
So, if a trader opens EUR/USD position of 1 lot, the cost of the point will be 100 000 * 0.0001 = 10 USD (as the dollar is quote currency). But if a trader reduces the volume of lot to 0.05, the cost will be 5000 * 0.0001 = 0.5 USD. Thus, profit (or loss) measured by a certain number of points in a position will be different in proportion to lot.
If EUR/JPY position in 1 lot is opened (or will be opened), cost of point will be 100 000 * 0.01 = 1000 JPY (as the yen is quoted currency). To convert yen to US dollars, a trader should divide cost of point into current exchange rate of USD/JPY (because for $1 you can get a certain amount of yen). So, 1 000 JPY / 89.94 = 11.11 USD.
One more example:
If EUR/GBP position in 1 lot is opened (or will be opened), cost of point will be 100 000 * 0.0001 = 10 GBP (as the pound is quoted currency). To convert pounds to U.S. dollars, a trader should multiply cost of point by current exchange rate of USD/GBP (as for 1 pound you can get a certain amount of dollars). So, 10 GBP * 1.4386 = 14.86 USD.