Forex Basics II

In this week’s post, we will be continuing with the second installment of “The Basics of Forex”. This week, we will be taking a look at the life of a typical Forex trade to see how the trader can utilize the power of margin to capitalize on technical and fundamental changes in the currency marketplace.

As we talked about two weeks ago, we know that when a trader places a trade in the Forex market, they are completing a variety of transactions. When a trader places a speculation on a particular currency pair, they are speculating that one of those currencies will strengthen or weaken in comparison to the other, therefore, they are selling one currency to buy another and vice versa when they exit the trade. Now before we get into lot sizes, margin ratios and margin calls, we need to refresh the idea of the minimum tick increment. The minimum tick increment is the smallest amount of fluctuation that can occur whether we’re talking about stocks, futures or currencies. In the Forex market, the minimum price fluctuation is called a “pip”. A pip is typically equal to 1/100 of .01. We’ll be making reference to this as we structure our various trading examples. Let’s take a look at some examples of actual Forex trades to see how the process plays out.

Below is a daily chart of the EUR/USD currency pair. For this example, we feel that the value of the Eurodollar will fall compared to a strengthening US Dollar. Because we are speculating that the Eurodollar will fall and/or the US Dollar will rise, we initiate a short position on this currency pair. To make money on this trade, we want to see the price action head lower. We initiate our short position at 1.2800. As with all risk management scenarios, we need to place a stop-loss order to limit ourselves from financial disaster. We place our stop-loss order in at 1.2900 to prevent the trade from going too far against us.

By trading a full lot of currency, we are controlling $100,000 of US Dollars with a 100-1 margin ratio. This means that we have invested $1000 of our money into a trade that allows us to control 100 times that amount. So what happens next? Well, if the trade goes against our short position and hits our stop-loss point at 1.2900, then we have lost our initial investment of $1000. Because this is a full-lot trade, each pip movement is equal to $10. So here is where we currently stand,

Initial investment = $1000
Amount of currency controlled = $100,000
Margin rate = 100 : 1
Entry price = 1.2800
Stop loss = 1.2900
Dollars risked = $1000
Dollar fluctuation per pip = $10 per pip

Now, as we can see in the chart below, the Eurodollar has weakened in comparison to the US Dollar. As the price action continues to move downward, our position is consistently improving from the perspective of profit and loss.

At the time this screenshot was taken, this trade has yielded nearly 900 pips. This translates to a profit of $9000 with a maximum risk of $1000.

Because the Forex market is a non-regulated and decentralized, there isn’t a central exchange that can mediate trade discrepancies. With this in mind, the trading of Forex instruments has changed dramatically over the last few years. In years past, traders that were margin called were basically hung out to dry due to the fact that many brokers would simply let the position run until the trader decided to close the position. This allowed for traders who lost all of their vested trade capital to go into steep financial loss as they not only lost all of their trading capital, but in many cases owed the broker several thousand dollars to make up the difference. Let’s equate this to our ongoing example. We decided to place a stop-loss order at 1.2900. This means that the maximum amount we would lose would be $1000. Once that stop loss was met, the trade would be closed. In the event that our stop was not filled, the broker would automatically close the position as our vested capital was now eaten away by the loss.

Another one of the changes that has been recently introduced was the ability to trade partial lots of currency. While some traders continue to trade the full lots of currencies, many brokers now allow traders to trade fractions of the full lot. Remember that one full lot controls $100,000 of US Dollars. Now days, traders can break the lots in fractions of 10. This basically allows traders to trade anywhere from 1/10th to 9/10th of a full lot. This is an added benefit as traders who wish to limit their exposure in the Forex market can do so by reducing their trade size more easily.

Let’s take a look at an example of this reduced size. If a trader has a speculation about the EUR/USD currency pair, they can choose to trade a 1/10th lot. This means that when a trader speculates on this currency pair, they will control 1/10th the amount of a full lot. When doing this, it not only limits the amount of money they can potentially lose, but it also limits the amount of money they can gain if the position becomes profitable. When a trader speculates on a partial lot, they are also bound by a tick increment that is also divided by the amount they are currently trading. Here is how the partial lot, minimum tick increment is structured.

1/10th lot = $1 per pip
2/10th lot = $2 per pip
3/10th lot = $3 per pip
4/10th lot = $4 per pip
1/2 lot = $5 per pip
6/10th lot = $6 per pip
7/10th lot = $7 per pip
8/10th lot = $8 per pip
9/10th lot = $9 per pip
1 full lot = $10 per pip

and so on…..

The Power of Margin

One of the greatest draws to Forex trading comes in the form of the leverage, or what is also known as margin. Margin is available in many forms. Stocks can be margined, futures are margined by nature and Forex almost always needs to be margined because the minimum tick increment. While many brokers allow clients to utilize margin, the rates they offer can vary from broker to broker. While the standard margin rate for currency pairs is 100 to 1, some brokers will allow traders to use leverage that is closer to 200 to 1. This translates to a client buying a full lot of currency with a vested capital amount of $500. If at any time their account balance equals or drops below their margin requirement, the dealer will liquidate all of their positions. The power of margin allows traders who do not have a significant amount of funds in their account to trade various currency pairs. The downside to this trade off is that if the trader does not immediately begin to grow that capital through a profitable trade or series of profitable trades, they may find themselves out of the game.

In the final installment in this series of Understanding Forex, we will be taking a look at the nature of spreads, currency arbitrage, and how the Forex market works from an institutional point of view.

Trade Smart....

~Duane Gott

 

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Comments

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