How to trade Forex? Forex spread and high leverage explanation

Now, when we know what is traded in the Forex market, we need to understand major mechanism of trading and get the idea of what Forex spread and high leverage are.

Transactions made in the Forex market are called positions. There are two types of positions:

  • BUY means buying a financial instrument while expecting rise in quotation;
  • SELL means a position held with expectation that asset will fall in value.

Let's remind that "Buy" position is also called a "long position", as it is noted, that the value of the exchange rate usually increases long and slowly. Opposite, "Sell" is called a "short position", as the value of the exchange rate often decreases very fast.

- Suppose a trader predicts U.S. dollar is getting weaker against Euro, then he sends BUY EUR/USD order (purchase Euros);
- If a trader assumes Euro is getting weaker against the U.S. dollar, SELL EUR/USD order should be sent (sell Euros).

The facts above can be applied to all currency pairs. Thus, a trader can earn on both growth and drop of exchange rates.

The exchange rate submitted by seller or buyer is called currency quotation. There are two quotations for each currency pair:

  • Ask (Offer) means the higher price in quotation; price at which trader can buy;
  • Bid (Last) means the lower price in the quotation; the price at which trader can sell.

Take a look at a typical representation of quotations:

As we see, EUR/USD = 1.2484/86 (which means Bid/Ask ratio). It means that a trader can buy Euro for the U.S. dollars at Ask price = 1.2486 or can sell Euro for the U.S. dollar at Bid price = 1.2484.

Forex spread explanation

Please note that sale price (Bid) is always less than buy price (Ask). The difference between buy and sell is called Forex spread. Spread is a traditional commission for a trading operation in any financial market, it is more familiar to us from currency exchanges. Spread may be fixed (permanent) and floating (vary over time). Forex spread usually depends on liquidity of a currency pair (trading activity) and terms of a broker. In general, at any time, spread can be expressed in the following form:

Forex Spread = Ask – Bid

In this case, spread is: 1.2486-1.2484 = 0.0002 or 2 points. Point or pip is a minimal change of the exchange rate. Thus, change in quote in one point for currency pair EUR/USD is equal to change in the last fourth number after decimal point. For example, changing from 1.2401 to 1.2402 or 1.2485 to 1.2486, etc. Changing in quote in 100 points is called a big figure.

Traditionally, almost in all currency pairs (EUR/USD, GBP/USD, USD/CHF etc.) one point is 1/10,000 ie 0.0001, and only for USD/JPY and cross rates that involve the Japanese yen - one point is 1/100 ie 0.01. But today many brokers tend to exact quotation, so do not be surprised if you see such quotes as 1.24849 for EUR/USD or 89,948 for USD/JPY. Of course, in this case one point will be equal to 0.00001 and 0.001 part of quote.

It is obvious, to buy something you need an exact amount of money. The same thing with the Forex market. When you conduct a trading operation, you must determine its volume. But the contract volume is specified in standard units of measurement – lots. It is accepted on the Forex market that:

1 lot equals to 100 000 of base currency

Let's remind that base currency is one that comes first in currency pair. So, when a trader opens 1 lot of euro/US dollar (EUR/USD), then volume of this contract is 100 000 euros, but if a trader opens 1 lot of US dollar/franc (USD/CHF), then volume of this contract will be 100 000 U.S. dollars. It is not necessary to start trading with such considerable sums of money. Volume of a transaction can be expressed in an incomplete (fractional) lot, for example

0.05 of lot amounts to 5 000 of base currency,

0.2 of lot amounts to 20 000 of base currency,

2.3 of lot amounts to 230 000 of base currency,

5 of lot amounts to 500 000 of base currency etc.

It is very important to understand that volume of the contract determines it's potential profit or possible losses in particular transaction(s), because it defines cost of one point when quotation changes. Originally,cost of point is always expressed in quoted currency (the one that takes second place in the currency pair). Let's look at the calculation:

cost of point in quoted currency = Lot * fraction of point

So, if a trader opens EUR/USD position of 1 lot, the cost of the point will be 100 000 * 0.0001 = 10 USD (as the dollar is quote currency). But if a trader reduces the volume of lot to 0.05, the cost will be 5000 * 0.0001 = 0.5 USD. Thus, profit (or loss) measured by a certain number of points in a position will be different in proportion to lot.

If EUR/JPY position in 1 lot is opened (or will be opened), cost of point will be 100 000 * 0.01 = 1000 JPY (as the yen is quoted currency). To convert yen to US dollars, a trader should divide cost of point into current exchange rate of USD/JPY (because for $1 you can get a certain amount of yen). So, 1 000 JPY / 89.94 = 11.11 USD.

One more example:

If EUR/GBP position in 1 lot is opened (or will be opened), cost of point will be 100 000 * 0.0001 = 10 GBP (as the pound is quoted currency). To convert pounds to U.S. dollars, a trader should multiply cost of point by current exchange rate of USD/GBP (as for 1 pound you can get a certain amount of dollars). So, 10 GBP * 1.4386 = 14.86 USD.

Now we definitely can say that we are done with terms "the volume of transactions" and "the cost of point". Let's look closer at mechanism of trading operations in the Forex market.

Let's assume that EUR/USD chart shows uprurge, i.e euro is rising against U.S. dollar.

Trying to catch this movement, we decide to open a long position (Buy) of 0.1 lot. In other words, at this moment we're going to control the amount of 10 000 base currency (in this case 10 000 EUR, because in EUR/USD, euro is the base currency). And then the most interesting part: if we do not have that sum of money, where can we get it?

Let's not get upset ahead of time and remember that in the Forex market most of the participants work with a broker. Usually broker is the one who provides traders with a required sum of money under the terms of margin trading. Margin trading means leveraged trading when trader may conduct transactions having far less funds on his/her trading account. For example, a leverage of 1:100 means that to purchase or to sale 10,000 of base currency you will need in hundred times less - only 100 of base currency. This amount is called margin and calculated in base currency in the following way:

Margin = Contract's volume/ Credit leverage

In our case, 10 000 EUR/100 = 100 EUR. To convert euros to U.S. dollars, a trader should multiply 100 EUR by current exchange rate of EUR/USD (because for 1 euro you can get a certain amount of U.S. dollars). So, 100 EUR * 1.2484 = 124.84 USD.

The point of margin is that it allows a trader to open positions of different volumes. As long as a position is open, broker holds a margin and does not allow a trader to open more positions. The question arises: what should we do if we want to open several trading operations at the same time? Well, then we can use two possible ways: have larger amount of money in account or use higher leverage.

The fact is leverage may vary from 1:1 to 1:500. For example, with position 10 000 of base currency and high leverage of 1:500 we will need margin of only 20 of base currency, instead of 100 of base currency (10 000/500). In this case, we can open several more orders with funds saved on margin.

Let's get back to our position and suppose that:

We have an account with $150 as deposit, leverage in the rate of 1:100, currency pair is EUR/USD and volume of position is 10 000 EUR.

We have opened a long position at 1.2486 (Ask) which means that we have bought 10 000 euros for U.S. dollars at rate 1.2486 and in the future they are suppose to be sold at higher price. For this transaction broker gave us 10 000 EUR * 1.2486 = 12 486 USD. Collateral = 10 000 / 100 * 1.2486 = 124.86 USD.

Let's imagine that our assumption comes true and EUR/USD has risen to 1.2586,which is 100 points.

In this case, we decided to close this position and gain profit. According to the rules of margin trading (under the terms which set our work with a broker), any open position should be closed with the help of the opposite position of the same volume. Therefore, upon closure of the position, a broker automatically exchanges our 10 000 euros back to US dollars, but at new higher rate 1.2586 (Bid). Thus, for 10 000 euros we get: 10 000 EUR * 1.2586 = 12,586 USD.

Broker gets 10,000 euros and no longer retain margin of $124. As for us, we get the difference between the sale price and purchase price: 12 586 - 12 486 = 100 USD.

So, this $100 goes into our account as the profit as soon as broker closes the position.

Thus, our deposit will now be $250 ($150 of starting deposit and $100 is the profit). By the way, MetaTrader 4 and MetaTrader 5, which we provide, allow you to see your profit in euros, dollars or rubles, depending on what type of account was opened.

Let's consider the case when something goes wrong and we made a mistake. For example, when price reaches $ 1.2436 (falls by 50 points).

We decide to limit loss and close position. Thus, for 10 000 euros we now get: 10 000 EUR * 1.2436 = 12,436 USD.

As it was in the first case, the difference has formed between sale price and purchase price: 12 436 - 12 486 = -50 USD

Unfortunately, it is our loss.

In this situation broker is not the one to blame. Brokerage company takes 10,000 euros from trader's account after closing a position as well as the lack of $50 plus spread (2 pips on EURUSD). Thus, our deposit will now be $98.

As you can see, a broker credits or debits result of a transaction only upon closure of a position. Up to this moment, financial result of transaction will be calculated and reflected as floating profit/loss. If you open more than one position, then you need to monitor total floating profit/loss . Besides, margin trading on Forex uses "Equity" parameter to show deposit status in case of an immediate closing of all positions on the account.

Equity = balance - floating loss + floating profit.

Let's consider the following situation: if we had not closed the position and the exchange rate continued to fall. Then loses would have also grown, reducing the amount of equity in account 150 .. 100 .. 50 .. 30 ... It should be noted that along with other indicators broker always calculates margin level as follows:

Margin level = Equity/ Margin * 100%

If margin level on accounts gets below 10%, then Stop-Out will automatically work, meaning a forceful closure of the most loss-making position. Obviously, it is not a broker's decision. It is just a necessity to keep money safe and allow other clients to trade freely.

In our example, Stop Out will work when funds are less than $4.12 (it is 10% from margin, because our margin is $ 124).

Conclusion: trader's own capital in the Forex market is only from 0.002 to 1% of all amount of operations he/she ever provides. Obviously, thanks to margin trading, there are much more potential possibilities for a trader: while keeping a relatively small deposit, a trader can handle very large amounts, therefore, profits can be ten times higher than the investment he/she used in trade.

Check Forex spread for currency pairs

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