How to Trade Currencies

How to trade currencies

To open a trading position, you will first of all need to decide whether you want to go long or short on a currency pair. You will then see two prices to place your trade – “ask” (buying) and “bid” (selling). The difference between the two is called the “spread”, and signifies how much the broker will charge you for making your trade.

Forex quotes are usually displayed up to four decimal places, for example, 1.2345. If we say the AUD/USD pair is 2.3456, you would need to spend 2.3456 USD for each AUD you want to buy.

A change in the value of a currency pair is usually seen in the fourth decimal place, or “pip”. Spreads, gains or losses in a trade are displayed as pips. For example, if you open a position at a quote of 2.3456 and it closes at 2.3458, your profit would be two pips.

What is leverage?

Leverage can be a useful tool for traders, as it will potentially let them reap greater rewards if they are successful in their investments. It does, however, act like a double-edged sword in that it can also magnify losses if the market turns against your prediction.

Traders will use leverage to open larger positions than their capital would otherwise allow. For example, if you were to open a trade of $100,000 using a leverage of 1:1, you would need to invest all of the money yourself.

Alternatively, you could use leverage to only invest a small amount of your capital and effectively borrow the rest from your broker. If you decide to open a trade of $100,000 at leverage of 1:100, for example, you would only need to put in $1,000 of your own funds.

If we assume that your $100,000 trade makes a profit of $1,000, you would only take away a 1% gain if you were using a leverage of 1:1. However, you would receive a profit of 100% if you were using a rate of 1:100.

The same is true if your investment makes a loss. If your position loses $1,000, then you would only make a 1% loss with 1:1 leverage, but a 100% loss using a rate of 1:100.

Understanding margin

The margin is effectively the amount of money you have to invest to open a trade. If we use the example of $100,000 above, then the margin would either be $100,000 using a leverage of 1:1, or $1,000 with a ratio of 1:100.

If you want to calculate the amount of margin needed to place your trade, just divide the deal amount by the leverage (for example, 100,000 / 100 = 1,000). A margin is always expressed as a percentage of your capital.

What are used and free margins?

A used margin is simply the amount of money that you have tied up in investment positions. For example, if you opened a $100,000 position using leverage of 1:100, your used margin would be $1,000 – assuming this was the only position you had open.

Free margins are any funds left over in your account that are not tied up in open positions. If we assume that you deposited $10,000 into your account and used $1,000 as margin, the free margin would be $9,000.

As long as this position did not move into negative territory, you would be able to use the full $9,000 to place new trades.

Margin calls

You will likely receive a margin call from your broker when the available equity in your account drops below the maintenance margin (the minimum amount you must have in order to keep your trades open). If this happens, you will be asked to deposit more funds, or your broker may decide to close open positions until your equity balance meets the margin requirement.

It is possible to protect yourself from a margin call using a number of methods, including stop loss orders – which reduce your exposure to risk. Another possibility would be to use a low amount of leverage, so that you are still improving your earnings potential, without making yourself too exposed if the market becomes volatile.

Bulls and bears

Throughout your investment career, you will likely hear the words “bulls” and “bears” a lot. These terms can be used to describe fluctuations in the market, or even traders themselves.

A bull market is where an asset is moving in an upwards trajectory (or trend), while a bear market is going in the opposite direction. Bull traders are said to be more aggressive in their actions, and will attack the market, while bears will be more defensive and pessimistic.

While the actual origins of these terms are not known, a popular theory is that they derive from how each animal attacks their opponents. A bull will thrust their horns in the air, while a bear will usually swipe downwards.