urrency Trading Basics #1 – Trading Versus Gambling
Currency trading is speculation, plain and simple. You’re speculating on the value of one currency versus another, with the sole intent of making a profit.
Some people call currency trading “gambling”. These are probably the same folks that call Forex trading easy.
Let’s set the record straight…
…currency trading is not gambling and it’s not easy.
With that said, if you’re not careful, Forex trading can become gambling. And it can become very easy to lose your money.
Currency Trading Basics #2 – Trade With A Plan
The key is being able to control your emotions. And the best way to control your emotions is to trade with a set of rules that you stick to.
These set of rules form your Trading Plan, which every trader must have in order to make consistent profits.
Without a Trading Plan to help you stay on course, it becomes easier for your emotions to take control and affect your decision-making ability.
That’s when trading turns into gambling, and chances are, you’ll eventually lose your hard-earned cash.
Treat your trading as a business.
And it’s perfectly okay if your trading becomes boring. It should be boring.
(I love the boredom of cashing checks, don’t you?)
Slow, steady, and consistent profits…
…that’s the name of the Forex game.
Save your emotions for the Las Vegas casinos!
Currency Trading Basics #3 – The Mechanics of a Currency Trade
In Forex currency online trading, what exactly happens when you make a currency trade?
Well, you’re exchanging one country’s currency for another country’s currency…
…hence the name, “foreign currency exchange” or “Forex” for short.
If you’re buying (going “long”) one currency, then you’re simultaneously selling (going “short”) another currency, and vice versa.
That’s why in Forex trading, you hold positions as a currency pair, such as USD/JPY (U.S. Dollar/Japanese Yen) pair.
Currency Trading Basics #4 – Every Transaction Is A Trade
If you think about it, any transaction you’ve ever made can be viewed the same way as a currency trade.
For example, if you were to buy a pack of chewing gum for $1 USD, you’re basically exchanging your $1 USD for 1 pack of chewing gum.
You’re buying 1 pack of gum by selling your $1 USD…
…or in trader’s terminology, you’re “long” 1 pack of gum and “short” $1 USD.
If you then sell your pack of gum to your buddy, who’s willing to exchange it for $3 USD, you would essentially close your open position in chewing gum.
You would sell your long position in gum to buy back your short position in USD for $3 USD.
You have now closed your long position in chewing gum, but with a $2 profit. Not bad!
Imagine if there was a country that actually uses chewing gum as its currency…
…hey, if you blew a bubble with your gum, would that be considered “inflation”?
Currency Trading Basics #5 – Currency Pair Designations
Let’s get back to reality and talk about real currency pairs.
In a currency pair designation such as USD/JPY, the currency on the left (USD) is the “base currency”, while the currency on the right (JPY) is the “counter currency”.
The base currency is the main currency you are buying or shorting. The counter currency is what you are selling in order to buy the base currency (or buying when you short the base currency).
The two currencies in a currency pair are always held in opposite directions from one another…
…one long, the other short.
Currency Trading Basics #6 – Currency Pair Categories
Forex currency pairs can be categorized into three groups…major currency pairs, minor currency pairs, and cross-currency pairs.
All major and minor currency pairs include the U.S. Dollar as one of the currencies in the pair. These include pairs such as EUR/USD, USD/JPY, and GBP/USD.
The “majors” are the most actively traded pairs, making up 80% of Forex trading volume.
Since they are the most actively traded, they tend to be the pairs with the highest liquidity and lowest spreads…great pairs for currency trading!
Cross-currency pairs do not include the U.S. Dollar. The most actively traded “crosses” include EUR/JPY, GBP/JPY, and EUR/CHF.
Currency Trading Basics #7 – Lot Sizes
A currency unit is a standard unit of value. For example, 1 currency unit of USD is $1. 1 currency unit of EUR is €1.
In Forex trading, currencies are bought and sold in fixed currency unit bundles, known as “lots”.
Forex brokers allow trading in one or more of the following lot sizes:
standard lot = 100,000 units of base currency
mini lot = 10,000 units of base currency
micro lot = 1,000 units of base currency
For example, if you wanted to go long 1 standard lot of USD/JPY, you would be buying $100,000 by selling an equivalent amount in Japanese Yen (depending on the ask price).
Currency Trading Basics #8 – Margin & Leverage
In the previous example, you might be wondering, “Do I really have to purchase $100,000 for a standard lot, or even $1000 for a micro lot? That’s a lot of money!”
Well, thanks to a concept called “leverage”, you don’t need a lot of capital to trade Forex.
When you open a Forex trading account online, your Forex broker will allow you to leverage the margin in your account.
The amount of leverage depends on the broker, but it can be as high as 500:1 at some brokers.
500:1 leverage means that you have 500 times the purchasing power for every $1 of margin. So $1000 allows you to purchase $500,000 worth of currency.
Be very careful with leverage. It magnifies profits, but it also magnifies losses. Ideally, you should trade with leverage no higher than 200:1.
Risk management, particularly proper position sizing, is just as important as trading strategy.
Don’t get greedy and risk too much capital on any one trade.
If you do, a losing trade has the potential of becoming a catastrophic loss that can wipe out a significant chunk of your account balance.
Currency Trading Basics #9 – Currency Pair Pricing
Prices for Forex currency pairs are always quoted in the denomination of the counter currency. It’s the “exchange rate”, the amount of counter currency equal to 1 unit of base currency.
As such, your profit or loss is always in the denomination of the counter currency.
There are actually 2 prices quoted for a currency pair…the bid rate and the ask price.
The bid rate is what you would sell the base currency for and the ask price is what you would buy the base currency for.
For example, let’s say the current price quotation for the USD/JPY is:
Bid 89.31 x Ask 89.33
This means that it would cost ¥89.33 to buy $1. At the same time, if you were to sell $1, you would receive ¥89.31.
Currency Trading Basics #10 – The Spread
The difference between the bid and ask price is called the “spread”.
As a trader, it would be in your best interest to find a good Forex broker who offered low spreads.
You could also trade during more active times of the day for your currency pair, when spreads tend to tighten due to the higher liquidity.
The lower the spread, the lower the number of pips to break even, and the higher your chances of making a profit.
A “pip” is the smallest price increment a currency can make. It’s how you measure your profit or loss.
As you can see in our previous example, as soon as you go long or short the USD/JPY pair, you’re already in the hole by 2 pips (the spread).
89.33 Ask minus 89.31 Bid = 2 pip spread
If you’re long, the currency pair would have to move up 2 pips in order to break even…
…a move higher than 2 pips and you’re in profit!
Currency Trading Basics #11 – Rollover Interest
When you trade Forex, your open position will consist of the currencies of two different countries.
Don’t forget that currency is money, and money itself has a price…interest.
The difference in interest rates between the two currencies in your open position is known as the “interest rate differential”.
If you’re holding an open position at 5 p.m. Eastern Time, you will either pay or earn the interest rate differential.
It depends on whether you’re holding the base currency long or short, and whether that base currency has a higher or lower interest rate than its counter currency.
The table below will help you determine whether you pay interest…
…or get paid interest. (Cha-ching!)
Currency Trading Basics Rollover Interest
If you’re holding a position that earns interest, it would be like having an “automoney machine” generating automatic cash flow for you.
Of course, the amount of interest you earn would depend on the size of your position.
Currency Trading Basics #12 – The Carry Trade
There is actually a long-term strategy known as the “carry trade” that takes advantage of this interest-rate differential. It could be worth looking into as a viable trading strategy.
However, if your trading strategy does not involve the carry trade, then don’t let rollover interest affect your trading decisions. The amount of interest earned or paid is usually insignificant relative to the amount of profits you’re going for.