How to Make Money Trading Forex

In the forex market, you buy or sell currencies.

Placing a trade in the foreign exchange market is simple: the mechanics of a trade are very similar to those found in other markets (like the stock market), so if you have any experience in trading, you should be able to pick it up pretty quickly.

The object of forex trading is to exchange one currency for another in the expectation that the price will change, so that the currency you bought will increase in value compared to the one you sold.

Example:

Trader’s Action EUR USD
You purchase 10,000 euros at the EUR/USD exchange rate of 1.1800 +10,000 -11,800*
Two weeks later, you exchange your 10,000 euros back into U.S. dollar at the exchange rate of 1.2500 -10,000 +12,500**
You earn a profit of $700 0 +700

*EUR 10,000 x 1.18 = US $11,800

** EUR 10,000 x 1.25 = US $12,500

 

An exchange rate is simply the ratio of one currency valued against another currency. For example, the USD/CHF exchange rate indicates how many U.S. dollars can purchase one Swiss franc, or how many Swiss francs you need to buy one U.S. dollar.

How to Read a Forex Quote

Currencies are always quoted in pairs, such as GBP/USD or USD/JPY. The reason they are quoted in pairs is because in every foreign exchange transaction, you are simultaneously buying one currency and selling another. Here is an example of a foreign exchange rate for the British pound versus the U.S. dollar:

 

The first listed currency to the left of the slash (“/”) is known as the base currency (in this example, the British pound), while the second one on the right is called the counter or quote currency (in this example, the U.S. dollar).

When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy one unit of the base currency. In the example above, you have to pay 1.51258 U.S. dollars to buy 1 British pound.

When selling, the exchange rate tells you how many units of the quote currency you get for selling one unit of the base currency. In the example above, you will receive 1.51258 U.S. dollars when you sell 1 British pound.

The base currency is the “basis” for the buy or the sell. If you buy EUR/USD this simply means that you are buying the base currency and simultaneously selling the quote currency. In caveman talk, “buy EUR, sell USD.”

You would buy the pair if you believe the base currency will appreciate (gain value) relative to the quote currency. You would sell the pair if you think the base currency will depreciate (lose value) relative to the quote currency.

 

Long/Short

First, you should determine whether you want to buy or sell.

If you want to buy (which actually means buy the base currency and sell the quote currency), you want the base currency to rise in value and then you would sell it back at a higher price. In trader’s talk, this is called “going long” or taking a “long position.” Just remember: long = buy.

If you want to sell (which actually means sell the base currency and buy the quote currency), you want the base currency to fall in value and then you would buy it back at a lower price. This is called “going short” or taking a “short position”. Just remember: short = sell.

 

Bid/Ask

EUR/USD forex quote
“How come I keep getting quoted with two prices?”

All forex quotes are quoted with two prices: the bid and ask. For the most part, the bid is lower than the ask price.

The bid is the price at which your broker is willing to buy the base currency in exchange for the quote currency. This means the bid is the best available price at which you (the trader) will sell to the market.

The ask is the price at which your broker will sell the base currency in exchange for the quote currency. This means the ask price is the best available price at which you will buy from the market. Another word for ask is the offer price.

 

The difference between the bid and the ask price is popularly known as the spread.

On the EUR/USD quote above, the bid price is 1.34568 and the ask price is 1.34588. Look at how this broker makes it so easy for you to trade away your money.

If you want to sell EUR, you click “Sell” and you will sell euros at 1.34568. If you want to buy EUR, you click “Buy” and you will buy euros at 1.34588.

Now let’s take a look at some samples.

Margin Trading

When you go to the grocery store and want to buy an egg, you can’t just buy a single egg; they come in dozens or “lots” of 12.

In forex, it would be just as foolish to buy or sell 1 euro, so they usually come in “lots” of 1,000 units of currency (Micro), 10,000 units (Mini), or 100,000 units (Standard) depending on your broker and the type of account you have (more on “lots” later).

“But I don’t have enough money to buy 10,000 euros! Can I still trade?”

You can with margin trading!

Margin trading is simply the term used for trading with borrowed capital. This is how you’re able to open $1,250 or $50,000 positions with as little as $25 or $1,000. You can conduct relatively large transactions, very quickly and cheaply, with a small amount of initial capital.

Let us explain.

Listen carefully because this is very important!

  1. You believe that signals in the market are indicating that the British pound will go up against the U.S. dollar.
  2. You open one standard lot (100,000 units GBP/USD), buying with the British pound at 2% margin and wait for the exchange rate to climb. When you buy one lot (100,000 units) of GBP/USD at a price of 1.50000, you are buying 100,000 pounds, which is worth US$150,000 (100,000 units of GBP * 1.50000).If the margin requirement was 2%, then US$3,000 would be set aside in your account to open up the trade (US$150,000 * 2%). You now control 100,000 pounds with just US$3,000.We will be discussing margin more in-depth later, but hopefully you’re able to get a basic idea of how it works.
  3. Your predictions come true and you decide to sell. You close the position at 1.50500. You earn about $500.
Your Actions GBP USD
You buy 100,000 pounds at the exchange rate of 1.5000 +100,000 -150,000
You blink for two seconds and the GBP/USD exchange rates rises to 1.5050 and you sell. -100,000 +150,500
You have earned a profit of $500. 0 +500

When you decide to close a position, the deposit 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.

What’s even better is that, with the development of retail forex trading, there are some brokers who allow traders to have custom lots. This means that you don’t need to trade in micro, mini or standard lots! If 1,542 is your favorite number and that’s how many units you want trade, then you can!

What is a Pip in Forex?

Here is where we’re going to do a little math. You’ve probably heard of the terms “pips,” “pipettes,” and “lots” thrown around, and here we’re going to explain what they are and show you how their values are calculated.

Take your time with this information, as it is required knowledge for all forex traders. Don’t even think about trading until you are comfortable with pip values and calculating profit and loss.

What the heck is a Pip? What about a Pipette?

The unit of measurement to express the change in value between two currencies is called a “pip.” If EUR/USD moves from 1.2250 to 1.2251, that .0001 USD rise in value is ONE PIP. A pip is usually the last decimal place of a quotation. Most pairs go out to 4 decimal places, but there are some exceptions like Japanese Yen pairs (they go out to two decimal places).

Very Important: There are brokers that quote currency pairs beyond the standard “4 and 2″ decimal places to “5 and 3″ decimal places. They are quoting FRACTIONAL PIPS, also called “pipettes.” For instance, if GBP/USD moves from 1.51542 to 1.51543, that .00001 USD move higher is ONE PIPETTE.

As each currency has its own relative value, it’s necessary to calculate the value of a pip for that particular currency pair. In the following example, we will use a quote with 4 decimal places. For the purpose of better explaining the calculations, exchange rates will be expressed as a ratio (i.e., EUR/USD at 1.2500 will be written as “1 EUR/ 1.2500 USD”)

Example exchange rate ratio: USD/CAD = 1.0200. To be read as 1 USD to 1.0200 CAD (or 1 USD/1.0200 CAD)

(The value change in counter currency) times the exchange rate ratio = pip value (in terms of the base currency)

[.0001 CAD] x [1 USD/1.0200 CAD]

Or Simply

[(.0001 CAD) / (1.0200 CAD)] x 1 USD = 0.00009804 USD per unit traded

Using this example, if we traded 10,000 units of USD/CAD, then a one pip change to the exchange rate would be approximately a 0.98 USD change in the position value (10,000 units x 0.0000984 USD/unit). (We use “approximately” because as the exchange rate changes, so does the value of each pip move)

Here’s another example using a currency pair with the Japanese Yen as the counter currency.

GBP/JPY at 123.00

Notice that this currency pair only goes to two decimal places to measure a 1 pip change in value (most of the other currencies have four decimal places). In this case, a one pip move would be .01 JPY.

(The value change in counter currency) times the exchange rate ratio = pip value (in terms of the base currency)[.01 JPY] x [1 GBP/123.00 JPY]

Or Simply

[(.01 JPY) / (123.00 JPY)] x 1 GBP = 0.0000813 GBP

So, when trading 10,000 units of GBP/JPY, each pip change in value is worth approximately 0.813 GBP.

Finding the Pip Value in your Account Denomination

Now, the final question to ask when figuring out the pip value of your position is, “what is the pip value in terms of my account currency?” After all, it is a global market and not everyone has their account denominated in the same currency. This means that the pip value will have to be translated to whatever currency our account may be traded in.

This calculation is probably the easiest of all; simply multiply/divide the “found pip value” by the exchange rate of your account currency and the currency in question.

If the “found pip value” currency is the same currency as the base currency in the exchange rate quote:

Using the GBP/JPY example above, let’s convert the found pip value of .813 GBP to the pip value in USD by using GBP/USD at 1.5590 as our exchange rate ratio. If the currency you are converting to is the counter currency of the exchange rate, all you have to do is divide the “found pip value” by the corresponding exchange rate ratio:

.813 GBP per pip / (1 GBP/1.5590 USD)Or

[(.813 GBP) / (1 GBP)] x (1.5590 USD) = 1.2674 USD per pip move

So, for every .01 pip move in GBP/JPY, the value of a 10,000 unit position changes by approximately 1.27 USD.

If the currency you are converting to is the base currency of the conversion exchange rate ratio, then multiply the “found pip value” by the conversion exchange rate ratio.

Using our USD/CAD example above, we want to find the pip value of .98 USD in New Zealand Dollars. We’ll use .7900 as our conversion exchange rate ratio:

0.98 USD per pip X (1 NZD/.7900 USD)Or

[(0.98 USD) / (.7900 USD)] x (1 NZD) = 1.2405 NZD per pip move

For every .0001 pip move in USD/CAD from the example above, your 10,000 unit position changes in value by approximately 1.24 NZD.

Even though you’re now a math genius–at least with pip values–you’re probably rolling your eyes back and thinking, “Do I really need to work all this out?” Well, the answer is a big fat NO. Nearly all forex brokers will work all this out for you automatically, but it’s always good for you to know how they work it out.

If your broker doesn’t happen to do this, don’t worry – you can use our Pip Value Calculator! Aren’t we awesome?

In the next section, we will discuss how these seemingly insignificant amounts can add up.

What is a Lot in Forex?

In the past, spot forex was only traded in specific amounts called lots. The standard size for a lot is 100,000 units. There are also a mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units respectively.

Lot Number of Units
Standard 100,000
Mini 10,000
Micro 1,000
Nano 100

As you may already know, the change in currency value relative to another is measured in “pips,” which is a very, very small percentage of a unit of currency’s value. To take advantage of this minute change in value, you need to trade large amounts of a particular currency in order to see any significant profit or loss.

Let’s assume we will be using a 100,000 unit (standard) lot size. We will now recalculate some examples to see how it affects the pip value.

  1. USD/JPY at an exchange rate of 119.80(.01 / 119.80) x 100,000 = $8.34 per pip
  2. USD/CHF at an exchange rate of 1.4555(.0001 / 1.4555) x 100,000 = $6.87 per pip

In cases where the U.S. dollar is not quoted first, the formula is slightly different.

  1. EUR/USD at an exchange rate of 1.1930(.0001 / 1.1930) X 100,000 = 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip
  2. GBP/USD at an exchange rate or 1.8040(.0001 / 1.8040) x 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.

Your broker may have a different convention for calculating pip value relative to lot size but whichever way they do it, they’ll be able to tell you what the pip value is for the currency you are trading is at the particular time. As the market moves, so will the pip value depending on what currency you are currently trading.

What the heck is leverage?

You are probably wondering how a small investor like yourself can trade such large amounts of money. Think of your broker as a bank who basically fronts you $100,000 to buy currencies. All the bank asks from you is that you give it $1,000 as a good faith deposit, which he will hold for you but not necessarily keep. Sounds too good to be true? This is how forex trading using leverage works.

The amount of leverage you use will depend on your broker and what you feel comfortable with.

Typically the broker will require a trade deposit, also known as “account margin” or “initial margin.” Once you have deposited your money you will then be able to trade. The broker will also specify how much they require per position (lot) traded.

For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account. No problem as your broker would set aside $1,000 as down payment, or the “margin,” and let you “borrow” the rest. Of course, any losses or gains will be deducted or added to the remaining cash balance in your account.

The minimum security (margin) for each lot will vary from broker to broker. In the example above, the broker required a one percent margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position.

How the heck do I calculate profit and loss?

So now that you know how to calculate pip value and leverage, let’s look at how you calculate your profit or loss.

Let’s buy U.S. dollars and Sell Swiss francs.

  1. The rate you are quoted is 1.4525 / 1.4530. Because you are buying U.S. dollars you will be working on the “ask” price of 1.4530, or the rate at which traders are prepared to sell.
  2. So you buy 1 standard lot (100,000 units) at 1.4530.
  3. A few hours later, the price moves to 1.4550 and you decide to close your trade.
  4. The new quote for USD/CHF is 1.4550 / 1.4555. Since you’re closing your trade and you initially bought to enter the trade, you now sell in order to close the trade so you must take the “bid” price of 1.4550. The price traders are prepared to buy at.
  5. The difference between 1.4530 and 1.4550 is .0020 or 20 pips.
  6. Using our formula from before, we now have (.0001/1.4550) x 100,000 = $6.87 per pip x 20 pips = $137.40

Remember, when you enter or exit a trade, you are subject to the spread in the bid/offer quote. When you buy a currency, you will use the offer or ask price and when you sell, you will use the bid price.

Next up, we’ll give you a roundup of the freshest forex lingos you’ve learned!

Major and Minor Currencies

The eight most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, NZD, and AUD) are called the major currencies or the “majors.” These are the most liquid and the most sexy. All other currencies are referred to as minor currencies.

Base Currency

The base currency is the first currency in any currency pair. The currency quote shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6350, then one USD is worth CHF 1.6350.

In the forex market, the U.S. dollar is normally considered the “base” currency for quotes, meaning that quotes are expressed as a unit of 1 USD per the other currency quoted in the pair. The primary exceptions to this rule are the British pound, the euro, and the Australian and New Zealand dollar.

Quote Currency

The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency.

Pip

A pip is the smallest unit of price for any currency. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit, that is, EUR/USD equals 1.2538. In this instance, a single pip equals the smallest change in the fourth decimal place – that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equal 1/100 of a cent.

Notable exceptions are pairs that include the Japanese yen where a pip equals 0.01.

Pipette

One-tenth of a pip. Some brokers quote fractional pips, or pipettes, for added precision in quoting rates. For example, if EUR/USD moved from 1.32156 to 1.32158, it moved 2 pipettes.

Bid Price

The bid is the price at which the market is prepared to buy a specific currency pair in the forex market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation.

For example, in the quote GBP/USD 1.8812/15, the bid price is 1.8812. This means you sell one British pound for 1.8812 U.S. dollars.

Ask/Offer Price

The ask/offer is the price at which the market is prepared to sell a specific currency pair in the forex market. At this price, you can buy the base currency. It is shown on the right side of the quotation.

For example, in the quote EUR/USD 1.2812/15, the ask price is 1.2815. This means you can buy one euro for 1.2815 U.S. dollars. The ask price is also called the offer price.

Bid/Ask Spread

The spread is the difference between the bid and ask price. The “big figure quote” is the dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, the USD/JPY rate might be 118.30/118.34, but would be quoted verbally without the first three digits as “30/34.” In this example, USD/JPY has a 4-pip spread.

Quote Convention

Exchange rates in the forex market are expressed using the following format:

Base currency / Quote currency = Bid / Ask

Transaction Cost

The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. For example, in the case of the EUR/USD rate of 1.2812/15, the transaction cost is three pips.

The formula for calculating the transaction cost is:

Transaction cost (spread) = Ask Price – Bid Price

Cross Currency

A cross currency is any pair in which neither currency is the U.S. dollar. These pairs exhibit erratic price behavior since the trader has, in effect, initiated two USD trades. For example, initiating a long (buy) EUR/GBP is equivalent to buying a EUR/USD currency pair and selling GBP/USD. Cross currency pairs frequently carry a higher transaction cost.

Margin

When you open a new margin account with a forex broker, you must deposit a minimum amount with that broker. This minimum varies from broker to broker and can be as low as $100 to as high as $100,000.

Each time you execute a new trade, a certain percentage of the account balance in the margin account will be set aside as the initial margin requirement for the new trade based upon the underlying currency pair, its current price, and the number of units (or lots) traded. The lot size always refers to the base currency.

For example, let’s say you open a mini account which provides a 200:1 leverage or 0.5% margin. Mini accounts trade mini lots. Let’s say one mini lot equals $10,000. If you were to open one mini-lot, instead of having to provide the full $10,000, you would only need $50 ($10,000 x 0.5% = $50).

Leverage

Leverage is the ratio of the amount capital used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a security with a relatively small amount of capital. Leveraging varies dramatically with different brokers, ranging from 2:1 to 500:1.

Now that you’ve impressed your dates with your forex lingo, how about showing her the different types of trade orders?

Types of Forex Orders

 

The term “order” refers to how you will enter or exit a trade. Here we discuss the different types of forex orders that can be placed into the forex market.

Be sure that you know which types of orders your broker accepts. Different brokers accept different types of forex orders.

There are some basic order types that all brokers provide and some others that sound weird.

Forex Order Types

Market order

A market order is an order to buy or sell at the best available price.

For example, the bid price for EUR/USD is currently at 1.2140 and the ask price is at 1.2142. If you wanted to buy EUR/USD at market, then it would be sold to you at the ask price of 1.2142. You would click buy and your trading platform would instantly execute a buy order at that exact price.

If you ever shop on Amazon.com, it’s kinda like using their 1-Click ordering. You like the current price, you click once and it’s yours! The only difference is you are buying or selling one currency against another currency instead of buying a Justin Bieber CD.

Limit Entry Order

A limit entry is an order placed to either buy below the market or sell above the market at a certain price.

For example, EUR/USD is currently trading at 1.2050. You want to go short if the price reaches 1.2070. You can either sit in front of your monitor and wait for it to hit 1.2070 (at which point you would click a sell market order), or you can set a sell limit order at 1.2070 (then you could walk away from your computer to attend your ballroom dancing class).

If the price goes up to 1.2070, your trading platform will automatically execute a sell order at the best available price.

You use this type of entry order when you believe price will reverse upon hitting the price you specified!

Stop-Entry Order

A stop-entry order is an order placed to buy above the market or sell below the market at a certain price.

For example, GBP/USD is currently trading at 1.5050 and is heading upward. You believe that price will continue in this direction if it hits 1.5060. You can do one of the following to play this belief: sit in front of your computer and buy at market when it hits 1.5060 OR set a stop-entry order at 1.5060. You use stop-entry orders when you feel that price will move in one direction!

Stop-Loss Order

A stop-loss order is a type of order linked to a trade for the purpose of preventing additional losses if price goes against you. REMEMBER THIS TYPE OF ORDER. A stop-loss order remains in effect until the position is liquidated or you cancel the stop-loss order.

For example, you went long (buy) EUR/USD at 1.2230. To limit your maximum loss, you set a stop-loss order at 1.2200. This means if you were dead wrong and EUR/USD drops to 1.2200 instead of moving up, your trading platform would automatically execute a sell order at 1.2200 the best available price and close out your position for a 30-pip loss (eww!).

Stop-losses are extremely useful if you don’t want to sit in front of your monitor all day worried that you will lose all your money. You can simply set a stop-loss order on any open positions so you won’t miss your basket weaving class or elephant polo game.

Trailing Stop

A trailing stop is a type of stop-loss order attached to a trade that moves as price fluctuates.

Let’s say that you’ve decided to short USD/JPY at 90.80, with a trailing stop of 20 pips. This means that originally, your stop loss is at 91.00. If the price goes down and hits 90.60, your trailing stop would move down to 90.80 (or breakeven).

Just remember though, that your stop will STAY at this new price level. It will not widen if market goes higher against you. Going back to the example, with a trailing stop of 20 pips, if USD/JPY hits 90.40, then your stop would move to 90.60 (or lock in 20 pips profit).

Your trade will remain open as long as price does not move against you by 20 pips. Once the market price hits your trailing stop price, a market order to close your position at the best available price will be sent and your position will be closed.

Weird Forex Orders

“Can I order a Grande extra hot soy with extra foam, extra hot split quad shot with a half squirt of sugar-free white chocolate and a half squirt of sugar-free cinnamon, a half packet of Splenda and put that in a Venti cup and fill up the “room” with extra whipped cream with caramel and chocolate sauce drizzled on top?”

Ooops, wrong weird order.

Good ‘Till Cancelled (GTC)

A GTC order remains active in the market until you decide to cancel it. Your broker will not cancel the order at any time. Therefore, it is your responsibility to remember that you have the order scheduled.

Good for the Day (GFD)

A GFD order remains active in the market until the end of the trading day. Because foreign exchange is a 24-hour market, this usually means 5:00 pm EST since that’s the time U.S. markets close, but we’d recommend you double check with your broker.

One-Cancels-the-Other (OCO)

An OCO order is a mixture of two entry and/or stop-loss orders. Two orders with price and duration variables are placed above and below the current price. When one of the orders is executed the other order is canceled.

Let’s say the price of EUR/USD is 1.2040. You want to either buy at 1.2095 over the resistance level in anticipation of a breakout or initiate a selling position if the price falls below 1.1985. The understanding is that if 1.2095 is reached, your buy order will be triggered and the 1.1985 sell order will be automatically canceled.