Forex Trading Examples (part 2)
You believe that signals in the market are indicating that the British Pound will go up against the US Dollar. You open 1 lot for buying the Pound with a 1% margin at the price of 1.49889 and wait for the exchange rate to climb. At some point in the future, your predictions come true and you decide to sell. You close the position at 1.5050 and earn 61 pips or about $405. Thus, on an initial capital investment of $1,000, you have made over 40% in profits. (Just as an example of how exchange rates change in the course of a day, an average daily change of the Euro (in Dollars) is about 70 to 100 pips.)
When you decide to close a position, the deposit sum that you originally made is returned to you and a calculation of your profits or losses is done. This profit or loss is then credited to your account.
Prices of foreign exchange are indicated by FOREX quotes in pairs of currencies. The first currency is the 'base' and the second is the 'quote' currency. In this example:
USD/EUR = 0.8419
...the currency pair is US dollars and European euros. The base currency (USD) is always at '1' and the quote currency shows how much it costs to buy one unit of the base currency. In this example, 1 US dollar costs 0.8419 euros.
EUR/USD = 1.1882
...tells us that it costs 1.1882 US dollars to buy 1 euro.
Example OCO Transaction:
Buy: 1 standard lot EUR/USD @ 1.3228 = $132,280
Pip Value: 1 pip = $10
This is an order to buy US dollars at 1.3328 and to sell them if they fall to 1.3203 (resulting in a loss of 25 pips or $250) or to sell them if they rise to 1.3328 (resulting in a profit of 100 pips or $1,000).
Here's another example:
The current bid/ask price for US dollars and Canadian dollars is
...meaning you can buy $1 US for 1.2152 CDN or sell 1.2157 CDN for $1 US.
If you think that the US dollar (USD) is undervalued against the Canadian dollar (CDN) you would buy USD (simultaneously selling CDN) and wait for the US dollar to rise.
This is the transaction:
Buy USD: 1 standard lot USD/CDN @ 1.2157 = $121,570 CDN
Pip Value: 1 pip = $10
Margin: $1,000 (1%)
You are buying US$100,000 and selling CDN$121,570. Your stop loss order will be executed if the dollar falls below 1.2147, in which case you will lose $100.
However, USD/CDN rises to 1.2192/87. You can now sell $1 US for 1.2192 CDN or sell 1.2187 CDN for $1 US.
Because you entered the transaction by buying US dollars (buying long), you must now sell US dollars and buy back CDN dollars to realize your profit.
You sell US$100,000 at the current USD/CDN rate of 1.2192, and receive 121,920 CDN for which you originally paid CDN$121,570. Your profit is $350 Canadian dollars or US$287.19 (350 divided by the current exchange rate of 1.2187).
The US dollar is normally considered the 'base' currency for Forex quotes. In the major pairs, this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/CAD 1.193 means that one U.S. dollar is equal to 1.193 Canadian dollars.
When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/CAD quote increases to 1.231, the dollar is stronger because it will now buy more Canadian dollars than before.
The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as EUR/USD 1.3027, meaning that one Euro equal 1.3027 U.S. dollars.
The initial margin to enter into a forex currency pair at Terra Nova is 3%. For example, an account is funded with $100,000 USD. A Forex currency trader feels that the US dollar is undervalued compared to the Canadian dollar. To capitalize on this strategy, the trader buys US dollars and simultaneously sells Canadian dollars. The current bid/ask for USD/CAD is 1.1835/1.1843 (purchase $1 US for $1.1843 CAD or sell $1 US for $1.1835 CAD).
The available leverage is 100:3 or 3%. To purchase a one lot, this trader buys $100,000 USD and sells $118,430 CAD. Using the above leverage, the initial margin is $3000 ($100,000 x 3%).
Trading on margin means that you can buy and sell assets that represent more value than the capital in your account. Forex trading is usually done with relatively little margin since currency exchange rate fluctuations tend to be less than one or two percent on any given day. To take an example, a margin of 2.0% means you can trade up to $500,000 even though you only have $10,000 in your account.
In terms of leverage this corresponds to 50:1, because 50 times $10,000 is $500,000, or put another way, $10,000 is 2.0% of $500.000. Using this much leverage gives you the possibility to make profits very quickly, but there is also a greater risk of incurring large losses and even being completely wiped out. Therefore, it is inadvisable to maximise your leveraging as the risks can be very high.
A pip is the smallest unit by which a cross price quote changes. When trading forex you will often hear that there is a 5-pip spread when you trade the majors. This spread is revealed when you compare the bid and the ask price, for example EURUSD is quoted at a bid price of 0.9875 and an ask price of 0.9880. The difference is USD 0.0005, which is equal to 5 "pips". On a contract or position, the value of a pip can easily be calculated. You know that the EURUSD is quoted with four decimals, so all you have to do is the cancel-out the four zeros on the amount you trade and you will have one pip. Thus, on a EURUSD 100,000 contract, one pip is USD 10. On a USDJPY 100,000 contract, one pip is equal to 1000 yen, because USDJPY is quoted with only two decimals.
A very common mistake made by novice forex traders is that they do not use a positive Risk/Reward ratio. By positive Risk/Reward ratio we mean the difference between the take-profit trade and the level of trade entry is greater than the difference between the stop-loss trade and the level of trade entry. In other words it means that you should not be willing to lose more than you want to make on a single trade.
Here is an example of a positive Risk/Reward ratio:
Buy EUR/USD 100,000 at 1.1500
T/P Sell EUR/USD 100,000 at 1.1600
S/L Sell EUR/USD 100,000 at 1.1440
In the above example the take-profit is 100 pips higher than the level at which the position was entered, and the stop-loss is 60 pips lower than the level at which the position was entered. The Risk/Reward ratio is 1:1.66.