The mechanics of forex trading are very similar to those of other markets such as the stock market, so if you have any trading experience, you should be able to grasp the basics in a short space of time. The aim of forex trading is to exchange one currency for another in the expectation that the price will change in your favour, so that the currency you bought will increase in value compared to the one you sold. For example, if you bought 10,000 pounds at the GBP/USD exchange rate of of 1.4100, you would pay 14,100 USD for them. If you then exchanged your 10,000 GBP for euros a couple of weeks later at the exchange rate of 1.5200, you would get 15,200 USD back, a profit of 1,100 USD.
The first thing you need to decide when looking at a currency pair is whether you want to go long (buy) or go short (sell).Going long, or taking a long position, on a currency pair implies that you want to buy the base currency and sell the quote currency, in the hope that the base currency will rise in value. Going short, or taking a short position, implies that you want to sell the base currency and buy the quote currency, in the hope that the base currency will fall in value so you can buy it back at a lower price.
All forex quotes are quoted with two prices, one for the bid price, and one for the ask price. The bid price is the price that the broker is willing to buy the base currency for in exchange for the quote currency. This means that the bid price is the best price at which you can sell to the market. The ask price is the price at which your broker will sell the base currency in exchange for the quote currency. This means the ask price is the best available price at which you can buy from the market. The difference between these two prices is known as the spread.
For example, if you saw this currency quote:
EUR/USD = Bid 1.3234, Ask 1.3243
The difference between the two (the spread) is 0.0009, or nine pips, which is approximately twice the broker’s profit margin on this currency pair.
There are many methods that traders use to decide which forex trades to make. One of the most common is known as fundamental analysis, which is the analysis of economic factors. We will cover this in greater detail in another chapter, so if you don’t fully understand this yet, just take it to mean any underlying factor that could cause predictable currency fluctuations. Here are a couple of examples:
In this pair, the euro is the ‘basis’ for the buy or sell trade. If you think that the US economy is going to weaken, which will be bad news for the US dollar, you would execute a BUY EUR.USD order, which basically means that you are buying euros in the expectation that they will rise against the U.S. dollar.
If, however, you reckon that the US economy is set to grow, which means that the dollar will probably rise against the euro, you would execute a SELL EUR/USD order in the expectation that the euro will fall against the US dollar.
In this pair, the U.S. dollar is the base currency and is therefore the basis for the buy or sell trade.
If you think that the Bank of Japan is set to weaken the yen in an effort to boost exports (as it often does), then you would execute a BUY USD/JPY order. This means that you are buying US dollars in the expectation that they will rise against the Japanese yen.
If, however, you have reason to believe that Japanese investors are going to take their money out of the US financial markets and their USD back to yen, which would hit the price of the US dollar, you would execute a SELL USD/JPY order. In doing so you would have sold U.S dollars in the expectation that they will fall against the Japanese yen.
In this pair, the U.S. dollar is the base currency and is therefore the basis for the buy/sell trade.
If you think that the Swiss franc is overvalued, you would execute a BUY USD/CHF order. This means that you would have bought U.S. dollars in the expectation that they will rise against the Swiss Franc.
If, however, you think that the difficulties in the US housing market will hurt the US economy and weaken the dollar, you could execute a SELL USD/CHF order, which means you would have sold U.S. dollars in the expectation that they will fall against the Swiss franc.