How Does A Forex Trade Work?

A Guide For The Forex Currency Trading Beginner

For the Forex currency trading beginner a trade can be a little confusing until you break it down and come to grips with some of the trading terminology.

The purpose of any Forex trade is to swap one currency for another in the belief that the market will move and prices change such that the currency that you buy rises in value in relation to the currency which you sell.

The first important point is that each trade involves two currencies - the currency which you buy and the currency you sell. This gives us our first two important trading terms - the long position and the short position.

You take a long position when you buy a currency in the belief that it will rise in value and that you will able to sell at a profit.

If you sell a currency in the belief that it will fall in value you take a short position and hope to make a profit by buying it back again once the price has fallen.

The next important concept is that of the open and closed position. When you take a long position and buy a currency in the expectation that it will rise in value you open a position. When you later sell that currency to take you profit you close the position. The same is true when you take a short position and open that position by selling a currency in the expectation that it will fall in price and later close the position when you buy the currency back at the lower price.

Note: How does day trading work? You will often hear the term ‘day trading’ used and this confuses a lot of newcomers to the world of investing. When applied to forex trading, day trading simply means short-term trading effected by opening and closing trading positions within the same trading day, rather than running a trade over an extended period of time.

In Forex trading currencies are referred to by codes (developed by the International Organization for Standardization and known as ISO codes) such as USD for the US Dollar and GBP for the UK Pound. Prices for these currencies are quoted as either USD/GBP or GBP/USD with the first currency appearing in the quote being the base currency and the second currency being the counter or quote currency.

Here’s an example quote to make things a bit easier to understand:

USD/GBP = 0.5260

In this case the US Dollar is the base currency and the UK Pound is the counter or quote currency. The base currency is always read as a single unit and so this quote means that it will cost 0.5260 UK Pounds to buy 1 US Dollar. Here’s another quote:

GBP/USD = 1.9150

In this case it will cost 1.9150 US Dollars to buy 1 UK Pound.

In real world trading it’s a bit more complicated as the market maker needs to add in his profit for selling you a currency or for buying currency from you. In reality therefore a quote might look more like this:

GBP/USD = 1.9238 1.9243

In this case the first figure is the ’sell’ or ‘ask’ figure and the second is the ‘buy’ or ‘bid’ figure. The first figure is price at which a trader will sell the currency pair and the second is the price at which he will buy the pair. The difference between the two prices is known as the spread.

Prices are normally quoted to four decimal places and the fourth decimal place, which represents the smallest amount by which one currency can move against the other, is known as a ‘pip’. In this case therefore the spread is 5 pips.

In our example therefore, if you wish to sell UK Pounds, the market maker will buy them from you at 1.9243 US Dollars per UK Pound and, if you wish to buy UK Pounds, 1 UK Pound will cost you 1.9238 US Dollars.

If you are just starting to learn Forex currency trading then this probably seems a little bit complicated but it represents the basis on which the Forex market operates and will quickly become second nature.

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