Forex in other words, foreign exchange is the process of converting one currency into another. The forex market is the most heavily traded financial market in the world.
What is Market?
Market is the platform where buyers and sellers can gather to ease the exchange of goods and services. There are many different types of markets, but we'll stick with financial markets here.
Financial Markets are divided into two: Money Markets and Capital Markets.
- Overnight interest
- Futures contracts shorther than 1 year
- Futures contracts longer than 1 year
Banks, organizations, and individual traders trade forex 24 hours a day, 5 days a week all over the world. Because there is no centralized marketplace for forex, unlike other financial markets, currencies are traded over the counter in whichever market is open at the time.
Forex has many advantages compared to other markets:
5/24 Tradeable Market: Forex enables the investors to trade 5 days and 24 hours without any time restrictions. By using trading platforms, investors are able to trade various products.
High Liquidity: Forex is the biggest financial market in the world.
In terms of daily trading volume, it provides every investor a chance to trade as much as they wish.
High Leverage: Most attractive feature of forex trading is leverage. By using leverage advantage, most of the investors are able to make much more profit with lower investment. On the other hand, leverage will affect your trade in both ways, which might bring large losses as well. Therefore, its important to designate the leverage ratio according to the expectations.
Two Sided Trading: Forex allows investors to trade both ways, buy or sell. For example, if you are expecting that the prices will go higher, you can go long (buy) trade. If your expectation is that the market go lower, then you can go short (sell) trade. Whether market is going higher or lower, investor can make money from both sides.
Narrow Spreads: One of the distinctive feature of forex is the narrow spread. Brokerage companies can offer much narrower spreads compared to banks and exchange offices. Therefore investors can trade with much lower costs.
Automated Order Transmission: It is also possible to trade forex through automated software.
Easy Access: Investors can trade forex from any electronic device which has internet connection (computer, mobile phone, tablet etc).
Companies and individual investors put their money into the currencies that will yield the best returns. If the interest rate on the Euro is higher than the interest rate on the US dollar, for example, demand for the Euro will increase, and the Euro's value will rise versus the US dollar. If the interest rate on the dollar is higher than the rate on the euro, the dollar will gain value. Furthermore, a positive effect on currency valuation might be created by a high interest rate forecast.
Macro Economic Reasons
The demand for imported goods and foreign currency will rise if the goods produced by the country with the highest inflation rate are more expensive than those produced by other countries. As a result, the country's currency will decline in relation to other currencies. In this circumstance, the central bank will raise interest rates in the near term, lowering the danger of inflation. Therefore, the value of the country's currency will rise. On the other hand, understanding which growth is founded on is crucial in order to better appreciate the impact of economic growth. It is critical to determine whether consumption or production is the source of growth. Imports rise as a result of consumption-based growth. As a result, there will be an increase in the demand for foreign money. As a result, the currency of the country will decline. If the country's growth is based on investment, production will rise and expenses will fall. As a result, exports will rise, and the country's currency will strengthen.
Capital movements have increased dramatically over time, and they have now surpassed foreign trade in importance. Money transfers were more rapid as a result of the opening of branches in every country and the advancement of technology. Therefore, foreign capital tends to go to locations where it can make more money. The capital's maturity range and the goal for which it acts, on the other hand, are both critical. While long-term and investment-oriented capital has a positive impact on the economy and employment in a country, capital movements targeted at profiting from short-term speculative movements, sometimes known as "hot money," generate fluctuations in foreign exchange balances.
It is the name given to the purchase and sale of a product in advance in order to profit from anticipated market price swings.
The impact of national, regional, and international political news on currency valuation is significant. Uncertainty in political issues or insecure enviroment can easily manipulate currencies. All political news and expectations can have a positive or negative impact on a country's economy.
High Volume Trading: In the Forex market, the leverage component necessitates a particular risk perspective. Leverage should be considered as a risk factor by investors. Putting the majority of the fund at risk in volatile market conditions can backfire.
Take Profit and Stop Loss Orders: Traders must follow a strategy and determine a price point at which to close a position. It is even more critical to identify price points in unpredictable market situations to avoid surprise losses. As a result, pending orders are a critical component of the approach.
Carry on with the Loss Position: If a loss is not discovered early enough, a significant portion of the capital may be lost, and the loss may be prolonged for a long time in the hope that the market would turn around.
Immediate Loss Closing: The anticipation of profit and the situation where the profit is expected to be at the highest level are the reasons why investors continue to lose money. Otherwise, the losses would not be covered, and the investment portfolio will steadily dwindle. Profitable trades must be closed at the maximum predicted price, while loss positions must be terminated at a manageable price point, in order to successfully manage your funds.
Emotional Behavior: It is important to stay calm while trading, otherwise we can not decide properly and may disobey our strategy.
Careless Trading: Financial markets are very serious business. There is no way to become successful investor without trading in discipline.
Trading in a Very Short Time: It is possible to make profit in very short time. But investors can feel pressure and it can become stressful if the market goes against the position.
Trading with Lack of Experience: Traders need to experience real trading environment by using demo accounts and increase their knowledge about trading. Otherwise investor’s trading experience will end up in disappointment.
Trading based on Indicators Only: Indicators only do not make sense for trading. It would be better to evaluate indicators with market analysis.
Trading Unplanned: Unplanned trading is really risky especially in volatile market conditions. Spontaneous trading can create non desired losses.
Disobey Stop Loss Price: Stop price is important to keep our loss at manageable point. Big amount losses can be difficult to handle and also discouraging for traders.
Trading Without Strategy: Implementing the strategy is as important as constituting the strategy.
There are two key terms in forex trading: currencies and currency pairs. The simultaneous purchase of one currency and the sale of another is known as forex trading. In the foreign exchange markets, a currency pair is a quote of the exchange rate for two different currencies. The first listed currency or base currency is purchased when a currency pair order is placed, while the second listed currency pair or currency pair is sold.
In the forex market, the US dollar is the most widely traded currency. Countries' currencies are abbreviated as USD (US Dollar), EUR (Euro), and GBP (Pound).
Term like USD/NZD or GBP/USD, on the other hand, expresses the currency of one country versus the currency of another.
If the GBP/USD parity is 1.3055, for example, you may buy 1.3055 USD for 1 GBP.
Currencies are traded in pairs and are traded through a "forex broker" or "CFD provider." The value of a currency is expressed in relation to another currency.
Currency Pairs can be divided into three groups: majors, crosses, exotics.
USD, EUR, JPY, GBP, CHF, CAD, AUD, NZD
Cross-currency pairs (also referred to as "minors."), or simply "crosses," are currency pairs that include any two major currencies other than the US dollar. For example EUR/GBP, CAD/AUD and GBP/JPY are minor currency pairs.
A currency from a developing or emerging market is known as an exotic currency. Exotic currency pairs combine one major currency with the currency of an emerging economy.
There are base and quote currency in a currency pair.
For example: USD/EUR. USD is the base currency and EUR is the Quote Currency.
The base currency serves as a reference point for the currency pair's exchange rate. It always has a value of one.
The exchange rate informs you how much you'll have to spend in quote currency units to acquire one unit of the base currency when you're buying.
Buy Price (Bid): Indicates the purchase price of any foreign currency of the brokerage company. Therefore, the investor can sell at this price.
Sell Price (Ask): It shows the selling price of foreign currency of the brokerage company. So, the investor can buy at this price.
Pip: Abbrevation of Price Interest Point words. Pip represent the minimum movement in price. Usually 1 pip change is the change in the fourth decimal place. For example, if the price of EUR/USD parity, which is 1.1200 increases by 1 pip, it means that the price is 1.1201. In some currencies, such as USDJPY, the smallest change can occur in the second decimal place. For example there is 1 pip movement from 109.55 to 109.56.
With the rapid growing markets and the increase in liquidity over the years, the spreads got narrowed and pip became insufficient. Therefore, parities are expressed as 5 digits today. For example, EURUSD 1.12015. Fifth decimal point is called as point.
Point: Defined as a fifth decimal point for the currency. It varies currency basis, it can also be the third decimal place for the one of the currency pairs.
Long Position: It refers to opening the position in the buy aspect. For example, buying transaction in EUR/USD parity means taking a long position in EURO and a short position in USD.
Short Position: It refers to opening the position in the sell aspect. For example, selling transaction in EUR/USD parity means taking short position in EURO and a long position in USD.
Profit-Loss Calculation: To calculate profit and loss, the contract size of the product should be multiplied by the the difference between closing price and opening price. If the currency on the right is not in USD, the amount should be converted to USD.
Equity: It shows the general condition of the account by including the profit or loss of all trade made in the account, including open positions. Equity amount is equal to the total collateral and balance that will remain after closing all trades in the account. The amount of equity varies according to the increase and decrease in the profit of your open position in your account.
Balance: The profit or loss of open positions does not change the balance, but the profit or loss obtained when these positions are closed is reflected in the balance. If there is no open position in the account, balance will be equal to equity.
Margin: Minimum required amount to open position.
As an example; If there is 1/100 leverage, investor is able to open 1 lot position by using $1000 as margin.
Margin Call: It is call for collateral completion that occurs when the account’s equity drops below the required equity amount.
Spread: It is called the difference between buy and sell in parities. For example, the spread (1.10763/1.10768) for this price point is 0.5 pip which is equal to 5 points.
Lot-Mini Lot: Trading units are called 1 lot in Forex, 100,000 units in trading parities, 100 ounces in gold, 5.000 ounces in silver. Standard lot is 100.000 units, 0.1 lot is called as mini lot which is 10.000 units. Similarly, 1000 units is defined as micro (0.01) lot.
Free Margin: The amount remaining from the equity to open a new position in the account after the opened position.
Leverage-Leverage Ratio: Calculated by multiplying the capital of the investor by the leverage ratio. Investors are able to trade a certain amount of their capital. For example, with a $ 10,000 capital and 1: 100 leverage, an investor can trade $ 1,000,000. The investor is responsible for the open positions as much as his capital and leverage will allow bigger trades to occur compared to the capital.
Swap: The rolling cost applied to your open positions at the end of the trading day to be carried to next day. This cost consists of the daily interest rate difference between the two currencies of the position’s parity. Spot positions that are opened and closed within the day do not have swap cost. This cost can be negative (-) or positive (+) according to interest difference between two currencies.
Parity: The ratio of currencies to each other.
Quotation: It is the buying and selling price of the products in the market.
Scalping: It is a trading strategy that is used in the Forex market and aims to profit from small price changes in short term trades.
Hedging: To open and close position in same amount for the same parity. For instance, there is 1 lot long EUR/USD open position. In order to hedge this position, the investor need to trade 1 lot short EUR/USD. By hedging the position, margin requirement will be zero.
Stop Out: If the equity amount drops to 10% of margin requirement, the system will automatically start from the position with the most loss and close until the required equity amount reaches 10%. According to agreement made with the investor, the stop out level may vary.
Buy Order: The base currency shown in a parity to buy in exchange for the counter currency.
Sell Order: The base currency shown in a parity to sell in exchange for the counter currency.
Stop Loss: It is used to prevent the investor from losing more than the risk trader has risked.
For example, 1 lot GBP/USD long position is opened at 1.3000 price point, but market goes against this position. To minimize the loss amount, trader puts a stop loss order at 1.2900 price point. Once, the price drops, position will be closed automatically by system.
Take Profit: It is the option of closing the position automatically when the market reaches the specified level in accordance with the idea that the price will move in opposite direction after reaching a certain level according to investor’s market opinion.
For example, in GBP/USD parity, the price is at 1.3000 level and it is thought that the parity will decrease again after 1.3100. In this case, if a profit order is placed at 1.3100, the system wil automatically close the position when the parity reaches 1.3100.
Buy Limit: It is the entry of a long position order below the market price of a pair.
For example, in GBP/USD parity, the market price is at the level 1.3000 and the buy limit order is at 1.2900. When the market price reaches the buy limit order level, the system automatically takes a long position.
Sell Limit: Entering a pending short position order above the market price.
For example, in GBP/USD parity, the market price is at level of 1.3000 and the sell limit order is at 1.3100. When the market reaches the sell limit order level, the system automatically takes a short position.
Buy Stop: If the pair price is thought to increase rapidly after breaking the resistance point, a buy stop order may be placed at the break point.
For example, let's assume that the GBP/USD pair is at 1.2880 and the first resistance is at 1.2900. We think that this resistance level will increase to 1.3300 after breaking. Accordingly, if we put the buy stop order at 1.2900, the buy stop order will automatically be active when the price reaches 1.2900.
Sell Stop: If the parity price is thought to drop rapidly after breaking the support level, a sell stop order may be placed at the break point.
For example, let's assume that the GBP/USD pair is at the 1.2920 level and the first support level at 1.2900. We think that this support level will decrease to 1.2500 after breaking. Accordingly, if we put the sell stop order at 1.2900, the sell stop order will automatically be active when the price reaches 1.2900.
How To Manage Margin Accounts?
Margin is an essential concept for forex trading. Margin trading allows investors to take positions that are larger than their account balance. So that, Investors have the opportunity to make phenomenally big earnings with only a minor shift in price going in their favor. On the other hand, the investor can get into a difficult situation with small price changes going against investor’s favor. Therefore, it is risky to trade without having comprehensive knowledge about the functioning of the margin account.
First of all, it is necessary to know what the following metrics mean and how they work. Each term will be discussed on the following sections.
The quantity of cash in an investor's trading account is measured by the Account Balance or simply Balance.
If $1,000 is deposited, the balance will be $1,000.
If a new trade is entered, the account balance is unaffected until the position is CLOSED.
As a result, the Balance will only change in one of three ways:
- When more funds are added to the account.
- When a position is closed.
- When a position is held open overnight and either receives or pays a swap/rollover fee.
When it comes to trading, there are two forms of "profit or loss," often known as "P/L."
The profit or loss maintained in open positions, or actively active trades, is referred to as unrealized P/L.
This is the profit or loss that would be "realized" if all open positions of all investors were promptly closed.
Unrealized P/L is also referred to as "Floating P/L" because the value fluctuates because the positions are still available.
Floating P/L = Lot x Contract Size x (Current Price - Entry Price)
Let’s assume an investor opens a long position in EURUSD 1 lot. Contract size is 100000 and It is bought at 1.18000. Then exchange rate is shifted and now it is 1.15000. What is the position’s floating P/L now?
Floating P/L = Lot x Contract Size x (Current Price - Entry Price)
Floating P/L = 1 x 100000 x (1.15000 - 1.18000)
-3000 = 100000 x (- 0.0300)
That mean’s there is a currently Floating Loss of $3000.
Let’s assume an investor opens a long position in EURUSD 1 lot. Contract size is 100000 and It is bought at 1.13000. Then exchange rate is shifted and now it is 1.15000. What is the position’s floating P/L now?
P/L = Lot x Contract Size x (Current Price - Entry Price)
P/L = 1 x 100000 x (1.15000 - 1.13000)
2000 = 100000 x (0.02000)
That mean’s there is a currently Floating Profit of $2000.
Let’s say, investor closes trade. That means profit of $2000 now is added to investor’s account balance. Assume that at the beginning of trade, investor had $10000 as his balance. After this trade is closed, investor has the balance of $12000. In other words, this is “realized profit”.
To create and maintain a new position in forex trading, investor just need to put up a little amount of money. The margin is the name given to this amount of money.
Margin is not a fee or a cost of transaction. It is merely a part of an investor's cash set aside by his forex broker from investor’s account balance in order to keep his trade open and assure that he can cover the trade's potential loss.
The "full position size," also known as the "Notional Value" of the position investor desires to open, is indicated as a percentage (percent) of the margin.
The Margin Requirement is a percentage (%) that must be met.
The Required Margin(Initial Margin) is the amount of margin expressed as a precise amount of investor’s account's currency.
Every position investor opens will have its own Required Margin, which must be "locked up."
When all of the Required Margin of all open positions is added up, the total amount is known as the Used Margin.
Free Margin is the money in a trading account that is accessible for trading in its most basic form. The margin of an investor's open positions must be reduced from his equity to compute Free Margin.
The current worth of an investor's trading account is represented by account equity or simply "Equity."
When viewing the trading platform, equity is the current worth of the account and fluctuates with every tick. In another words, It's the total of an investor's account balance plus all floating (unrealized) earnings or losses from open positions.
If no open positions exist, an investor's Equity equals his Balance.
The Margin Level is a percentage (%) figure based on the difference between the amount of Equity and the amount of Used Margin.
The more Margin Levels an investor has, the more Free Margin he or she has to trade with.
The Margin Call Level is reached when the Margin Level reaches a certain level or threshold in forex trading. When this level is reached, some positions will almost certainly be liquidated.
The "metric" is the "Margin Level," and the "Margin Call Level" is a particular "value" of the metric (which is the Margin Level).
Margin Calculation=Lot Size x Contract Size x Price / Leverage Ratio
(Lot Size x Contract Size x Price:Position Size)
Note: In margin calculation, the result always comes from the base part of the currency pair.
Opening Position with 1/100 Leverage Ratio:
Suppose an investor funds $10,000 to his account and the EURUSD parity is at 1.1000. The investor thinks that the Euro will gain value against US Dollar and therefore takes long position In this case:
- 1 Lot = 100,000 Euro.
- Since the price of the pair is 1.1000, there will be a 100,000x1.1000=110,000 position on 1 lot USD basis.
- As the investor is in long position, he buys Euro with 1 Lot and sells dollars in return. According to the 1.1000 EURUSD parity, he bought 100,000 Euro (1 Lot) and sold 110,000 USD.
With 1:100 leverage ratio, the margin rate to be deducted for this trade will be 1% and will be used from the free margin in the account. The investor’s balance will be equal to the free margin if there is no open position. When the position is opened, the margin requirement will be deducted from free margin.
Margin=100,000 Euro (Position Size) / 100 (Leverage Ratio) = 1.000€=1.100$
Free Margin: 8,900$
- 1 lot long position of 100,000 Euro or 110,000 USD when the price is 1.1000 will opened.
- If EUR/USD parity increase 1.1100 (100 pip upward movement)
1.1100 x 100,000 = 111,000$ - 110,000$ = 1,000$ profit has been made. Therefore 1 pip movement equals to $10 profit or loss.
An investor with a balance of 5,000 USD in his account and using a leverage of 1:100 has bought 2.2 lots of GBPJPY. Contract size is 100,000. The price at which the transaction takes place is 128.64. According to this;
a) What is the margin in USD that the investor should have in his account in order to carry out this transaction? What is the margin level and free margin amount in USD at the time of the transaction? (GBPUSD=1.2219, USDJPY=105.27 at the time of the transaction).
b) Suppose the GBPJPY pair rises to 130.24 after executing the trade. What is the profit/loss situation of the investor? What are the assets, free margin amount and margin level related to your account? (New quotes: GBPUSD=1.2269, USDJPY=106.15. Spread is insignificant.)
c) Suppose the GBPJPY pair drops to 126.41 after executing the trade. What is the profit/loss situation of the investor? What are the assets, free margin amount and margin level related to your account? (New quotes: GBPUSD= 1.2116, USDJPY= 104.33)
d) Assuming the customer's Stop Out level is 30%, after what price level will the customer's trade be closed automatically? How much assets are in the client's account at the time the trade is closed?
a) 100,000 (Contract Size) x 2.2 (Lot Size) / 100 = £2,200 (Margin)
2,200 x 1.2219 = $2,688.18
Free Margin: 2,311.82$
Margin Level: 5,000/2688.18*100 = 185.99%
b) Floating P/L = (Current Price - Entry Price) x Lot x Contract Size
(128.64-130.24) * 100,000 * 2.2 = - 352,000 JPY
-352,000/106,15 = -3,316.0621 USD (Loss)
Equity: 5,000-3,316.0621= $1,683.9379
Free Margin: 1,683.9379-2,688.18= -$1,004.2421
Margin Level: 1,683.9379/2,688.18*100 = 62.6423%
c) Floating P/L = (Current Price - Entry Price) x Lot x Contract Size
(128.64-126.41) * 100,000 * 2,2 = 490,600 JPY
490,600 /104.33 = 4,702.3866 USD (Profit)
Equity: 5,000+4,702.3866= $9,702.3866
Free Margin: 9,702.3866-2,688.18= $7,014.2066
Margin Level: 9,702.3866/2,688.18*100 = 360.927%
d) 2,688.18 x 30/100= $806,454
If this price level is reached, customer's trade be closed automatically.
Lets assume, an investor deposits $10,000 to his account and the USDTRY parity is at 5.5000. The investor who thinks that the USD will move up opens long position.
1 lot = 100,000 units =100,000 USD.
- When the price of the currency pair is 5.5000, 1 lot will have a position of 100,000 x 5.5=550,000 TRY.
- Investor is trading 1 lot long USDTRY, so it means buying $100,000 and selling 550,000 TRY.
1% of the position size will deducted as a margin from account’s free margin. Before opening any position, free margin is equal to balance.
Margin 100.000 USD (Position Size) / 100 (Leverage Ratio) = 1,000 USD.
Free Margin :4,000$
- With 1 lot of trade, an upward position of 100,000 dollars and 550,000 TRY will be opened while the parity is at 550,000.
- If USD/TRY parity moves to 5.5100 (100 pip upward movement);
1 x (5.5100 – 5.5000) x 100,000 =1,000 TRY profit has been made.
Therefore, 1 pip movement equals to 10 TRY profit or loss.
Let's say an investor deposits $ 5000 to his account and suppose that gold is at $ 1550.00. The position to be taken by the investor waiting for the gold to gain value will be the long position (1 lot = 100 ounces)
When the ounce price of the pair is 1550, 1 lot will then represent a position size of 100x1550 = $ 155,000. Since the investor is buying, he buys gold with 1 lot and sells dollars in return. In this case, the investor will buy 1 lot of 100 gold (ounces) and sell $155,000.
Due to the 1/100 leverage ratio, 1% of the position will be used as a margin from the free margin on the account. The investor's balance is equal to the free margin before any transactions are made. When the transaction is opened, the required margin will be deducted from the amount of free margin.
Lets assume Spot Gold is $1550, for 1 lot trade;
Margin=100 ounces x 1550 / 100 = 1550 USD
Free Margin: 3450$.
- With 1 lot long Spot Gold trade, when the price is $1550, a position is opened $155.000 with upward move expectation.
- If Spot Gold’s price moves to $1560 ($10 upward movement)
1x1560x100=156.000-155.000=1.000$ profit has been received. Therefore, every 10 cent price change is equal to $10 profit or loss.