Open 24 hours a day 5 days a week, the foreign exchange market is the largest and most liquid market in the world with volumes of over $5.3 trillion a day surpassing any exchange based market. Foreign exchange trading involves trading one currency pair against another, predicting that one currency will rise or fall against another. Currencies are traded in pairs, like the Euro versus the US Dollar (EUR/USD).
How Does Forex Trading Work?
Forex trading is similar to trading shares or futures except that when trading foreign exchange, you are buying or selling one currency against another and you do not take delivery of the underlying currency. One of the key advantage Forex has over other financial instruments is that relatively small lot sizes can be traded, lot sizes can be as small as 1000 units or one micro lot. Typically, foreign exchange also involves leverage which in some cases can be as high as 1:500, this is very different to trading shares where no leverage is involved. Leverage allows traders to trade with more money than they actually have in their trading account. For example, if you had 1:100 leverage you could use a $1,000 deposit to control $100,000 worth of currency. Using leverage can result in an increase in you gains however if not used correctly if can also result in increased losses.
Forex Trading Example
Opening the Position
The price of the EURO against the US Dollar (EUR/USD) is 1.33623/1.33624, you decide to sell 2 standard lots (the equivalent of €200,000) at 1.33623.
The value of your position is €200,000 x 1.33623 = USD $267,246. The leverage on your trading account is 1:100 therefore the margin required to open the position is USD $267,246 / 100 = USD $2,672.46.
Closing the Position
One week later the EURO has fallen against the US Dollar to 1.32128/1.32129, you decide to take your profit by buying back 2 standard lots at 1.32129.
The gross profit on your trade is calculated as follows:
|Opening Price||€200,000 x 1.33623 = USD $267,246|
|Closing Price||€200,000 x 1.32129 = USD $264,259|
|Gross Profit on Trade||USD $ 2,988|
It is important to note that whist your position remains open, each night your account will be debited or credited the swap rate. The swap is expressed in pips and is the difference between the interest paid to borrow the currency that is being sold and the interest received from holding the currency that is bought.
In order to calculate the net profit on this trade your will need to include any swap charges, you may also need to include any commission charges if they are payable. You should be aware that if the market had moved in the opposite direction, you would have made a loss that could have exceeded your initial deposit.