Decision Dilemma: To Buy or to Sell?
Before executing an order, you need to decide whether to buy or sell, driven by the expectation of a profit. Fundamental analysis is one way of choosing whether to go long or short. When using fundamental analysis to make a decision, you need to assess economic performance of respective countries.
For instance, if you are buying EUR/USD you will look at economic factors such as manufacturing, employment, productivity, international trade, and interest rates of European Union and the United States.
If you believe that the United States will be stronger economy, you sell the pair. That would mean you are selling the EUR and buying USD, expecting the USD to become stronger and the EUR to weaken.
Sometimes a country can decide to weaken its currency to increase exports. This would cause their currency to become weaker. For example, if you think Japan will devalue its currency for that reason, you buy USD/JPY, expecting the Japanese Yen to become weaker and the USD to become stronger.
If you believe that the base currency is overvalued, you have to sell the pair to make a profit with the expectation that the base currency will depreciate relative to the quote currency.
What is margin trading?
Currencies are often sold in lots. A lot is a bundle of units of a currency such as:
- 1,000 units (micro)
- 10,000 units (mini)
- 100,000 (standard)
However, you may not have enough money to buy so many units of a currency. Margin trading can help you buy as much units as you want with a small amount of money.
Margin trading refers to the capability of a forex trader to use borrowed capital to trade. With as little as $500, one is able to open a trade of over $10,000. This allows a trader to execute many transactions using a small amount of money.
Practically, assume you want to buy 10,000 units of EUR/USD at 1.3000. This means that you are buying 10,000 units of the Euro at $1.3000 per unit. So you will spend $13,000. But since you do not have so much money, you borrow capital with a margin of 5% for example.
This would mean that you need $650 (5% x $13,000) in your account to execute the trade. So you have control over 10,000 GBP with $650 only. If you close the trade at 1.3200, you get returns of $200.
Once you close an order (always called a position in forex trading), your initial capital of $650 will be deposited in your account, and the profit of $200 will be added, and your account reads $850. If it is a loss, it is subtracted from your account.
If your position remains open beyond the “cut-off time” of your broker, you will either earn or pay an interest rate called the rollover based on your position and margin. The cut-off time is usually 5 P.M. EST. You can close the position before this time to avoid earning or paying the interest rate.
You pay interest if the interest rate of the currency you are buying is lower than the interest rate of the currency you are borrowing, and vice versa.
What is a Pip in Forex Trading?
Forex trading requires a comprehensive knowledge of pips and lots. A pip is a measurement unit that shows how a currency has changed with respect to another.
Consider a EUR/USD quote of 1.2100, and the price moves to 1.2101. This change is a rise of 1 pip. A pip is determined by looking at the last decimal place of the quote.
If the decimal places of a quote is different from the usual 4 or 2 decimal places, the quote involves a fractional pip, which is also called a pippete – 1.23321. A pipette is usually a tenth of a pip. In the above quote:
1 = 10,000 pips 2 = 2,000 pips 3 = 300 pips 3 = 30 pips 2 = 2 pips
1 = 0.1 pips
Example: EUR/USD = 1.3200 >> 1 EUR / 1.3200 USD.
Pip = change in counter currency x exchange rate ratio
Pip = (0.0001 USD) x (1EUR/1.3200USD) = 0.00007576 EUR per unit traded. NB: 1 pip would change in value by 0.0001.
So if you trade 10,000 units of EUR/USD, then a change of the exchange rate by one pip will cause a change in value of the position by approximately 0.76 EUR.
Confused? Relax! Your broker always calculate all this stuff for you, so you do not need to scratch your head over it. But you may need to know how these things are calculated anyway.
What about a Lot?
Currencies are often exchanged in lots of 100 (nano), 1,000; 10,000; and 100,000. Changes in currencies relative to each other (pips) are always very small, so you need to trade in large amounts of the currencies to get good return.
For a EUR/USD quote of 1.2300 and a lot of 10,000 = (0.0001/1.2300) x 10,000 = 0.813 EUR per pip.
What is a leverage value in Forex Trading?
Leverage is the ability of the trader to use a large amount of money using a small amount of deposit. A leverage of 100:1 would mean that you will be required to have 1% of the required lot. If you want to buy a lot of 100,000 U.S.D. (standard lot), you will be required to have 1% of 100,000 = $1,000 as deposit or margin in your account.
You need to maintain your equity of at least the deposit value, so any trade with a loss that will bring the account amount below the equity amount will be closed automatically.