How to Make Money?

 

Essentially, forex trading is buying one currency and selling another.  Hopefully the currency you bought will raise in value and turn a profit for you.  Here is an example below:

Trader’s Action

You purchase 10,000 euros at the EUR/USD exchange rate of 1.1800

Two weeks later, you exchange your 10,000 euros back into U.S. dollar at the exchange rate of 1.2500

You earn a profit of $700
*EUR 10,000 x 1.18 = US $11,800
** EUR 10,000 x 1.25 = US $12,500

The ratio of one currency valued against another is the exchange rate.  USD/EUR shows how many euros someone can buy with the US dollar.

 

Reading Forex Quotes

The first currency listed in a pair is called the base currency and is the basis.  The second currency is called the counter currency or quote currency.  In a currency pair, you would sell the pair if you believed the base currency will depreciate, and buy the pair if you thought the base currency will go up in value.
 

Long/Short
First you have to determine whether you want to buy or sell.  In traders talk, “going long” means you want the base currency to go up in value so you can sell it back to turn a profit.  Long = Buy.

When you want to sell, “going short” means you want the base currency to fall in value so you can buy it back at a lower price.  Short = Sell.
 

Bid/Ask
All forex quotes are quoted with two prices.  The bid is the price your broker is willing to buy the base currency in exchange for the quote currency.  Essentially, the bid price is the best available price for the trader to sell to the market.

The ask price is the opposite and is the price at which your broker will sell you the base currency in exchange for the quote currency.  The offer price is another way of saying the ask price.

The difference between the bid and ask prices is known as the spread.

 

When to Buy or Sell a Currency Pair

Let’s look at the currency pair USD/JPY.  The USD is the base currency, so if you believe the US economy will strengthen, then you would execute a buy USD/JPY.  You would execute a sell USD/JPY if you think the US economy will weaken.  

Margin Trading

In forex, nobody buys or sells just 1 Euro.  They come in “lots” of 1000 units of currency (micro), 10,000 units (mini), or 100,000 units (standard).  This also depends on what broker you are using and the account type you have with your broker.

Not everybody has enough money to buy 10,000 USD.  Margin trading allows people to trade with essentially borrowed capital.  Large transactions can be conducted with little amount of initial capital.  Here is an example below:

  1. Market analysis makes you believe that the US dollar will go up against the Euro.
  2. You open one standard lot (100,000 units USD/EUR), buying with the US dollar at 2% margin while waiting for the exchange rate to climb.  Buying one lot (100,000 units) of USD/EUR at the price of 1.50000, you are buying 100,000 dollars, which is worth 150,000 euros (100,000 USD *1.50000).  If the margin requirement was 2%, then 3,000 euros would be set aside in your account to open up the trade (150,000 euros * 2%).  Now you control 100,000 dollars with just 3,000 euros.
  3. Let's say your predictions come true and you now want to sell.  You close the position at 1.50500 so you make 500 euros.

The profit or loss is credited to your account after you close a position.  Some brokers even allow for custom lot sizes.

 

Rollover

The trader pays or earns a daily rollover or interest rate for positions open at your broker's cut-off time (usually 5:00 pm EST).  Interest is paid on the currency that is sold and earned on the currency which is bought. 

If the interest rate is higher with the currency you are buying, then there will be a positive net interest rate differential.  On the flip side, if there is a negative interest rate differential and you will have to pay. 

Different brokers or dealers have different rules regarding rollover so check with them.  Leverage and interbank lending rates can also be deciding factors.  The benchmark interest rates for the major currencies are listed below.

Country Interest Rate
United States 0.25%
Euro Zone 0.15%
United Kingdom 0.50%
Japan 0.10%
Canada 1.00%
Australia 2.50%
New Zealand 3.50%
Switzerland 0.00%

 

What a Pip is in Forex?

Simply put, a pip is the unit of measurement that expresses the change in value between two currencies.  If USD/EUR moves up from 1.2249 to 1.2250, that .0001 raise in value would be one pip.  It is usually the last decimal place in a quotation.  There is an exception with the Japanese yen pairs that only go out to two decimal places.

*****IMPORTANT*****

Currency pairs are quoted in some brokers beyond the “4 and 2” decimal places to “5 and 3” decimal places.  These are called fractional pips or “pipettes.”  For example, a one pipette movement would be 1.52456 to 1.52457.

Each currency in a pair has its own relative value, so it’s important to calculate the value of a pip to each currency in the pair.

Example

  1. USD/EUR = 1.0202.  We would read this as one USD to 1.0202 EUR or euros.  
  2. Pip value = The value change in counter currency X the exchange rate (in terms of the base currency).
  3. [.0001 EUR] X 1 USD/1.0202 EUR] or just [.0001/1.0202] X 1 USD = .00009802 USD per unit traded.
  4. If we traded 10,000 units of USD/EUR, then a 1 pip exchange rate would be about .98 USD change in value.
  5. Remember with the Japanese yen there are only two decimal places used.  So with the pair GBP/JPY at 122.00 it would be [.01] / 122.00 X 1 GBP = .00008197.  With 10,000 units, each pip value would be worth approximately .819 GBP.

 

How to determine pip value in your account denomination

Not every trader has their account denominated in the same currency since it is a global market.  Finding the pip value in terms of your account currency is very important.  So whatever currency your account is traded in, you have to find the pip value for that currency.

  1. All you have to do is multiply/divide the “pip value found” by the exchange rate of the currency in your account and the currency in question.
  2. Using the GBP/JPY example above, to convert the found pip value of .819 GBP to the pip value in USD by using GBP/USD at 1.5591 as our exchange ratio.
  3. .819 GBP per pip (1 GBP / 1.5591 USD) or essentially (.819) / (1) X (1.5591 USD)= 1.2769 USD per pip.
  4. This says that for every .01 pip move in GBP/JPY, for every 10,000 units, the position changes by 1.28 USD.
  5. Also, multiply the pip value found by the conversion exchange rate ratio if the currency you are converting to is the base currency of the conversion exchange rate ratio

Forex brokers will do this math for you, but it’s good to know.  There are also apps and other programs that offer pip value calculators!

 

Lots in the Forex World

Spot forex used to only be traded in lots, which are specific amounts.  Below is a list of different lots and the number of units in each lot.

Lot Number of Units
Standard 100,000
Mini 10,000
Micro 1,000
Nano 100

 

To see a noticeable profit or loss in the forex world, large amounts of currency needs to be traded.  Let’s use a 100,000 unit (standard) lot size to see how it affects some of the pip values.

  • USD/JPY at an exchange rate of 117.76 (.01 / 117.76) X 100,000 = $8.49 per pip.
  • USD/CHF at an exchange rate of 1.4545 (.0001 / 1.4545) X 100,000 = $6.88 per pip.

The formula is a little different when the USD is not quoted first.

  • EUR/USD at an exchange rate of 1.1722 (.0001 / 1.1722) X 100,000= 8.53 X 1.722 = $14.69 per pip.
  • GBP/USD at an exchange rate of 1.8025 (.0001 / 1.8025) X 100,000= 5.55 X 1.8025 = $10 per pip.

The pip value will move as the market moves depending on which currency you are trading.  Don’t forget, your broker will help you determine the pip value.

 

Leverage

  • Small investors can trade large amounts of money with leverage.  Brokers basically fronts $100,000 in the same way a bank would.  All the broker wants is a deposit of $1,000 for this.  The amount of leverage you use depends on what you feel comfortable with and your broker.
  • Brokers will let you know how much they require for each lot traded.  You will be able to trade once you make your trade deposit, also known as “initial margin” or “account margin.”
  • Let’s say you wanted to trade a position worth $100,000.  Your broker tells you the allowed leverage is 100:1 (1% of position required), but you only have $5,000.  What happens is that your broker would take $1,000 as an initial margin or down payment, and essentially let you “borrow” the rest.  Gains and losses are deducted or added to the leftover cash balance in your trading account.

 

Calculating Profit and Loss

Let’s use an example and pretend we are buying US dollars and selling Swiss francs.

  1. The quoted rate is 1.4525/1.4530.  Traders are willing to sell Swiss francs at the “ask” price of 1.4530, since we are buying US dollars.
  2. Then you buy one standard lot (100,000 units) at 1.4530.
  3. You decide to close your trade later after the price moves to 1.4550.
  4. The new quote for USD/CHF is 1.4550/1.4555.  You must now take the “bid” price of 1.4550 because you are now closing your trade and selling, so that is the price traders are willing to buy at.
  5. The difference between 1.4530 and 1.4550 is .0020 or 20 pips.
  6. Now let’s use the formula from before, (.0001 / 1.4550) X 100,000 = $6.87 per pip X 20 pips = $137.40.

Exiting the trade makes you the subject of the bid/offer quote.  Use the ask price for buying currency and the bid price for selling currency.

 

 

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