Written by Robert McKinley

How Forex Works

In the Foreign Exchange Market (FOREX) you buy one currency while simultaneously selling another currency. That is why currency exchange rates are always quoted in pairs. For example: GBP/USD (British pounds/U.S. dollars).

When you buy a currency, your expectation is that the price of the currency you bought will increase in value (appreciate) in relation to the currency you sold or, conversely, if you sell a currency, your expectation is that the price of the currency you sold will decrease in value (depreciate). Also, when you buy a currency it is called "going long" or just "long" and when you sell a currency it is called "going short" or just "short." It's easy: Buy = Long and Sell = Short. You will learn more about this later.

Currency Pairs

Again, currency rates are quoted in pairs because in every foreign exchange transaction one currency is bought while another is sold. It is a simultaneous transaction.

The currency listed to the left of the slash ("/") is known as the base currency and the currency listed to the right of the slash ("/") is called the counter or quote currency. For example, with the GBP/USD currency pair, GBP is the base currency and USD is the counter or quote currency.

Exchange Rates

An exchange rate is the ratio of the value of one currency compared to the value of another currency. For example, the GBP/USD exchange rate indicates the value of British pounds compared to U.S. dollars and U.S. dollars compared to British pounds.

Example exchange rate: GBP/USD = 1.3900 tells us that it would cost 1.3900 U.S. dollars to buy 1 British pound. Also, if you wanted to sell 1 British pound, you would receive 1.3900 U.S. dollars on the sale.

So you see, the base currency is the "basis" for either a buy or a sell transaction.

• If you buy (go long) EUR/USD this means that you are buying the base currency and simultaneously selling the quote currency.
• Further, you buy the pair when you think the base currency will increase in value (appreciate) relative to the quote currency and,
• conversely, you sell (go short) the pair when you think the base currency will decrease in value (depreciate) relative to the quote currency.

Transaction Example

1. You buy (go long) 10,000 Euros at the EUR/USD exchange rate of 1.29
2. It costs you 12,900 U.S. dollars. (Much less out-of-pocket with a margin account.)
3. If the Euro appreciates to 1.39 (GBP/USD = 1.3900) against the U.S. dollar and you decide to exchange the Euros you bought, back into U.S. dollars, you would receive 13,900 U.S. dollars in the transaction for a profit of 1,000 U.S. dollars. (13,900 you received in the sale minus 12,900 you paid when you bought the Euros.)

Once again, you buy a pair (go long) when you think the base currency (the first one in the pair) will appreciate and you sell a pair (go short) when you think the base currency will depreciate.

Bid/Ask Spread

There are two prices in all FOREX quotes-the "bid" and the "ask."

• The bid is always lower than the ask.
• The bid is the price at which the dealer is willing to buy the base currency in exchange for the quote currency. Thus, the bid is the price at which you (the trader) can sell.
• The ask is the price at which the dealer will sell the base currency in exchange for the quote currency. Thus, the ask is the price at which you can buy.
• The difference between the bid and the ask price is known as the "spread."

GBP/USD Price Quote Example

1. The bid price is 1.3950 and the ask price is 1.3954.
2. To buy GBP, you click "Buy" and you will have bought British pounds at 1.3954.
3. To sell GBP, you click "Sell" and you will have sold British pounds at 1.3950.

To Buy Or To Sell, That Is The Question!

We list many Courses and eBooks on this website that can help you learn whether to buy or sell and when to do either one. You will also find Forex trading software that can tell you if and when it is a good idea to make a trade and even do the trading for you, automatically. Meanwhile, here are a couple of very simple examples of how you might go about making these decisions.

Example 1:

EUR/USD (Euro is the base currency and thus the "basis" for the buy/sell.)

You expect the U.S. economy will continue to weaken, and that the Euro will appreciate against the U.S. dollar, so you decide to execute a Buy EUR/USD order. If you expect the opposite to happen, you would, logically, decide to execute a Sell EUR/USD order.

Example 2:

USD/JPY (USD is the base currency and thus the "basis" for the buy/sell.)

Because you have been watching the world economic news, you believe that the Japanese Yen is going to weaken (depreciate) against the U.S. dollar. Therefore, you decide to buy the USD/JPY pair in the expectation that the U.S. dollar will appreciate against the Yen. But if you see a different scenario in which you believe the Yen will strengthen against the dollar, you would, logically, decide to sell the pair.

So it goes. Again, take a look at the many FOREX Courses and eBooks we offer to find one or more to help you get up-to-speed as a successful trader.

Will I need a big bankroll to trade?

Not with margin trading! With margin trading you can make $10,000 or $100,000 trades with as little as $50 or $1,000. In other words, you can make large transactions with a small amount of capital. This is one of many reasons that FOREX is so attractive to so many people. It's called "leverage."

Margin Trading

FOREX margin trading is measured in "lots." A lot is the minimum amount of currency you must buy or sell if you decide to place a buy/sell order. It is done this way because the market would not function properly if traders could buy or sell just one Euro or one Dollar at a time. So, typically, lots are set at 10,000 in a "Mini" account or 100,000 in a "Standard" account. You can learn more about this later. Meanwhile, remember margin accounts and the leverage they provide.

Pips/Points: One unit of price change in the bid/ask price of a currency. It is the last digit in a rate; the fourth decimal place in an exchange rate. This is a very important term to know because currency trading in the FOREX market is measured in Pips/Points.

Example of trading in lots:

You have done some research and you believe that the British Pound will go up against the US dollar.

1. The exchange rate at the time is 1.5000 (GBP/USD = 1.5000).
2. You buy one lot (100,000) of GBP/USD at 1% margin and wait for the exchange rate to appreciate.
3. You have just bought 100,000 British pounds at a price of 1.5000, which is worth US$150,000 (100,000 units of GBP x 1.5000 (the exchange rate with USD)). Since you bought the lot in a 1% margin account, the purchase of 100,000 British pounds only cost you 1% of US$150,000. So it cost you US$1,500.
4. To complete the transaction (open the trade), your broker has set aside US$1500 of your money in your account. You now control 100,000 British pounds with a US$1500 investment.
5. As you predicted, the pound has appreciated to 1.5050 (GBP/USD = 1.5050) and you decide to sell.
6. You close your position at 1.5050. You earn 50 pips (see definition above) or about $500. (This is a good time to do the calculation yourself so you will fully understand what happened.)
7. Finally, after you closed your position, the 1% deposit you originally made is returned to you. Then a calculation of your profit is made and it is credited to your account. Of course, if you had experienced a loss, it would have been deducted from your account.

Rollover

In the spot FOREX market trades settle in two business days. If a trader sells 10,000 Euros on Tuesday, the seller must deliver 10,000 Euros on Thursday unless the position is held open and "rolled over" to the next value date.

Rollover (also known as "cost-of-carry") involves the applying of a daily debit or credit to a trading account based on positions held open at 17:00 (5 PM) Eastern Time and on the interest differential between the two currencies in the pair(s) being traded. In the majority of cases, if a trader is "short" the currency bearing the higher interest rate, their account will be debited; if they are "long" then their account will be credited.

For example, a short USD/JPY position will incur an interest charge because one is effectively "short" US Dollars and "long" Japanese Yen. Dollar short-term interest rates are currently at 3.5% while Yen rates are around 0.5%-a negative 3% difference. This interest differential forms the basis of the daily premium debit/credit, which is applied to all open trades at 17:00 Eastern Time, Monday through Friday each week.

Of course, if you decide that you do not want to maintain your position(s) overnight and do not want to earn or pay interest on your positions, then simply close them before the end of the market day. Also, be sure to learn what the rollover policies of your broker or dealer are.

NOTE: In a currency trade, you borrow one currency from your broker to buy another currency. Hence, interest rollover charges are a common part of FOREX trading. Interest is paid on the currency that is borrowed and interest is earned on the currency that is bought. Therefore, if a trader buys a currency with a higher interest rate than the currency he or she has borrowed, the net difference in interest rates will be positive and the trader will earn money as a result. (Again, be sure to learn what the rollover policies of your broker or dealer are.)

Demo Accounts

Good brokers provide free demo accounts, which have all of the same capabilities as "real" trading accounts. They provide these accounts because they want you to become familiar with their trading platforms and the services they provide in the hope you will decide to stay with them and open a live account with real money.

Again, with a free demo account you can trade exactly the same way as you would in a live account with real money. You will see the same market movements that real-money traders see and you can place orders and take positions with ZERO RISK. So, whatever else you do, be sure to open a demo account and use it to learn how everything works and to develop your skills before you open a live account with real money.