How is FX Traded?

Example of an FX Trade

If you think that the Euro will rise relative to the U.S. Dollar, you would buy one lot of the EUR/USD currency pair:

• The EUR/USD is trading at 1.2553 when you buy it.
• The EUR/USD is trading at 1.2674 when you sell it.
• You bought at 1.2553 and sold at 1.2674 for a profit of .0121 or 121 pips.
• Each pip is worth $1 in the 10K account.
• 121 pips x $1 = $121 profit

In FX, you also have the opportunity to short (sell first) a currency pair if you think it will fall in price.
If you think that the Euro will fall relative to the U.S. Dollar, you would sell one lot of the EUR/USD currency pair:

• The EUR/USD is trading at 1.2659 when you sell it.
• The EUR/USD is trading at 1.2523 when you buy it.
• You bought at 1.2523 and sold at 1.2659 for a profit of .0136 or 136 pips.
• Each pip is worth $1 in a 10K account.
• 136 pips x $1 = $136 profit

While these are profitable examples, a trader could have lost the same amount by being on the wrong side of the trade.

What is the significance of currency pairs?

A currency pair represents the exchange rate between the two currencies. For example, the rate at which the EUR/USD is trading represents the number of U.S. Dollars one Euro can purchase. The first currency is called the base currency and the second currency is called the counter currency.

An example of how currency pairs trade is if a trader believes the Bank of Japan will intervene to cause a decrease in the Yen against the U.S. Dollar, then the trader would buy USD/JPY (buy the U.S. Dollar/sell the Yen). However, if the trader believes that Japanese investors are losing faith in the United States' economy and are pulling money out of the U.S. into Japan, then the trader would sell USD/JPY (sell the U.S. Dollar/buy the Yen).

This is an example of how currency pairs are listed on trading stations.

The currency pairs are listed on the left side of the column. The sell price is the level at which a trader can sell the currency pair and the buy price is the level at which a trader can buy the currency pair.

What is leverage?

Leverage allows traders to borrow money and use that money to invest in the foreign exchange market. Because of leverage, clients without a huge amount of capital are able to make large investments, whereas in other markets such as the equities market, clients would have to pay 50% of the full amount for each share of stock they were investing in. Most market makers allow positions to be leveraged up to 100:1. This means that if a trader wanted to buy a "lot" worth $100,000, with 100:1 leverage the trader only has to put up $1,000.

Leverage is about risk. Increasing your leverage increases both your opportunity to take bigger profits AND rack up bigger losses.

It's easy to see in the graph below that the amount of margin required in taking positions in the currencies market is much less than in the equities and futures markets.

What is margin?

Margin is a performance bond, or good-faith deposit, to ensure against trading losses. The margin requirement allows traders to hold a position much larger than their account's value. FXCM's most lenient margin requirement is .5%. FXCM' s online trading platform has margin management capabilities, which allows for this high leverage.*

In the event that funds in the account fall below margin requirements, all open positions are triggered to close. This is designed to prevent clients' accounts from falling into a negative balance, even in a highly volatile, fast-moving market.

For example, let's say you have an account with $10,000. That means you have $10,000 of usable margin. If you use $7,000 to buy seven lots of USD/JPY, you now have $3,000 of usable margin left, meaning that you are allowed to lose $3,000 before you are under the margin requirement. The account equity remains at $10,000 until you begin to make or lose money on the position. Now, if the USD/JPY decreases to the point that you end up losing the $3,000 that is left in your account, then all open positions are triggered to close to ensure that you do not lose more than you have in your account.

How are leverage and margin related?

Leverage and margin are related in the way mentioned above–the amount of leverage a market maker gives to a client defines the amount of margin that the client will have to commit to in order to take a position in the market. For example, when leverage is 100:5, the "5" in the leverage ratio signifies the amount of capital the customer has invested of his own money, which is also known as the margin.

How much does it cost for a trader to make a trade?

Traders do not take positions on a currency pair at the exact rate at which the currencies are valued. Instead, there are two rates for the currency pair: the bid rate and the ask rate.

• The bid rate is the price at which traders can sell the pair.
• The ask rate is the price at which traders can buy the pair.

This is an example of a currency pair. The ask (buy) rate is higher than the bid (sell) rate and the spread is 3 pips, meaning that if a trader buys this pair, then the sell rate of this pair will have to go up 3 pips in order for the trader to break even.

The ask rate will always be higher than the bid rate. The difference between the bid rate and the ask rate is the spread. The spread is an automatic cost that the trader incurs when making the trade. Because of this spread, traders will take a position they started with a small loss and will need to gain some profit in order to break even.

For example, if a trader buys into a position at the ask rate, and then immediately closes the position at the bid rate, the trader will incur a cost equal to the spread. These spreads are seen in every kind of market. However, because of the broker-based system in the equities and futures market, it can sometimes be difficult to identify where and how much the spread cost is.