How to Make Profit from Forex Trading
How does it work?
Forex trading is simply the process of exchanging one currency for another. Most are traded against the dollar. Other highly traded currencies are the pound, euro, yen, Swiss franc, and Australian dollar.
The first currency quoted in the currency pair on Forex is called base currency, which is the domestic currency and the second currency is known as the quoted currency and is typically the foreign currency.
Example: If you were trading in rupee-dollar, the rupee would be the base currency and dollar the quote currency. The price shows how much the quote currency is required to get one unit of the base currency.
In the market, the volume of trade is shown in the base currency. Example: In a 100,000 rupee-dollar trade, 100,000 is the face value and is a standard contract. No matter which currency you have in the account, the trading software automatically sets your exchange rate.
The profit or loss in trade is shown in the quote currency, as the currency pair price is given in it. For instance, if you buy the euro-dollar at 1.3010, and sold it at 1.3020, your profit is 10 pips or $0.0010 for each euro. Pip is the smallest measure of the price move on an exchange.
Each trade has the two prices – bid and ask. The bid price is the rate at which the broker buys, and you get on selling. The asking price is the offer price at which the broker sells, and you pay to buy. The difference between the bid and ask price is the spread.
In a euro dollar at 1.4000/1.4003, the spread is 3 pips. On trading 100,000 euro dollar, the broker earns 100,000 x 0.0003 = $30, irrespective of your profit or loss. If the currency pair rises 10 pips, you learn only 7 pips because you bought at 1.4003 and sold at 1.4010.
Typically, a lower spread is better for the traders, as it gives you a higher profit.
Leverage and Margin
In the case of a small investor who invests, say, $1,000, if the price moves up by 1% you will earn $10 and your broker only $0.30. It’s not a great deal for you, worse for your broker. 30 cents will barely justify his salary.
Ergo is the concept of leverage financing where the trader deposits only considered risk, and the broker provides the rest. Margin requirements vary from one to 5%, depending on the broker. A margin of 1% may translate into a trade of up to $100,000, even if you have only $1,000 in the account. The margin corresponds to a 100:1 leverage.
Applying a 100:1 leverage, as above, you and the broker’s profits are multiplied by 100: you get $1,000, and the broker gets $30. The flip side if the price falls 1%, your entire capital is lost.
On opening the trading position, you can designate a part of your capital as collateral on margin, then it will be set aside and protected. On a capital of $3,000, say, your margin is $1,000. You use $2,000 to trade, and if you lose, the broker closes your position, and you will get back the collateral.
Let’s assume you bought 100,000 units of euro-dollar at $1.3227, which rose to 1.3237. You quickly sell those units and get $100 back. But, if the rate decreases to 1.3217, you stand to lose $100.
Some losses are inevitable for any trader. Though, the key is to limit losses by using the stop-loss and controlling risk. If you set a limit order, you would have realized the potential profit without having to observe the trade closely.