Forex Trading Made Simple
Currency trades are always done in pairs between the currencies of two different countries. Below are listed two sample currency pairs.
Name Bid Ask Change %Change High Low Time
EUR/USD 1.1901 1.1903 -0.0091 -0.76% 1.2024 1.1891 15:26
GBP/USD 1.7439 1.7442 -0.0004 -0.02% 1.7573 1.7410 07:01
Taking the one listed in the first line, let’s look at how a sample Forex investment might evolve over time.
As shown in the price listing, the ask price for the EUR/USD currency pair is 1.1903. Remember the ask price is that at which brokers are willing to sell the base currency (EUR). In this example that means we can buy the base currency (EUR) for $1.1903.
The bid price is listed as 1.1901. Remember the bid price is the price at which brokers are willing to buy the base currency (EUR). In this example that means we can sell the base currency (EUR) for $1.1901.
Unless you have something that brokers are now beginning to offer called a ‘mini’ account, all trades are done in standard lots of 100,000 units. So, to get in the game, you (theoretically) have to shell out $119,030 to purchase one standard lot of 100,000 euros.
To professional currency traders, that’s a tiny amount of cash. To the average investor interested in Forex trading it’s enormous. That’s one of the reasons some brokers are beginning to offer ‘mini’ accounts. Mini accounts have much smaller standard lots, such as 10,000 units.
Even at 1/10th the standard size, that’s still a substantial investment for many investors. Even professionals will balk at having to come up with the full cash amount for large trades. Forex brokers deal with this problem by offering something called ‘leverage’.
Leverage is the ability to control much more than you own. Forex brokers ‘loan’ an investor typically up to 90% or more. It isn’t technically a loan. The 10% or less actually invested is regarded, in the industry and in law, as a ‘good faith deposit’. The investor is technically on the hook for the other 90% or more, but it’s very rare to press an investor for the money.
Instead, if the price direction moves in an unfavorable direction (for the investor) by a large enough amount, the broker simply liquidates the position and the investor loses! It’s important to realise this! A good broker will usually give the client a call and give him or her the option to input enough fresh cash to cover the shortfall.
Currency prices can change by significant amounts very quickly (that’s called ‘volatility’), though, so be prepared.
What might that look like in a realistic scenario?
Let’s look at the above example EUR/USD 1.1901/03. Bid price is 1.1901 and ask price is 1.1903 and suppose trades are done at 1:100 (1%) leverage. You decide to buy EUR. In the case of 1 standard lot of 100,000 units, you put up 1% of $119,030, or $1,190.30.
Let’s take a look at the profit potential.
Suppose the market moves to EUR/USD 1.1907/09. If you sell the euros at this point, the bid price will apply. In this case you make a profit of …
$119,070 – $119,030 = $40.
That doesn’t sound like much, but observe two things.
One, the initial investment ‘out of pocket’ was only $1,190.30, and 1% of $119,070 = $1,190.70, only a 40 cent! difference ($0.4). Yet the actual profit was 100 times that, $40. That multiplier effect on the actual profit is the result of leverage.
Second, price changes of a few pips can (and often do) happen in minutes in the Forex markets, and getting in and out doesn’t cost a formal commission. Brokers make money off the spread. Investors can get in and out quickly and accumulate large amounts of profit (or loss) in one day. Or, they can wait for wider swings – which also often happens in relatively short periods.