Mechanics of Forex Trading (learn forex online)

Placing an Order

Orders to buy or sell currencies can be placed any time the market is open. With most trading platforms, placing a forex order is as easy as a click of the mouse.

If a trader wishes to buy a currency pair, he is said to be taking a long position on that pair. The trader who is long will profit when the currency pair increases in value. A trader who sells a currency pair is said to be going short. That trader will profit if the currency pair decreases in value.

It is an important principle to understand that the forex trader can place an order to sell a currency pair that he does not "own". To exit that "short trade", the trader simply places an order to buy the currency pair in the future. See below for more information on exiting trades.

More about long and short in forex trading

The concepts of buying, selling, long and short can be confusing in currency trading, since in every forex trade one currency is exchanged for another - essentially there is a buy/long and a sell/short in every trade. For simplicity, it might be easiest to think of a currency pair as being an abstract financial instrument to which a price is assigned by the forex market.

At the same time, it is important to maintain perspective and remember that the abstract-appearing instrument, in a very real way represents the actual relative value of two very real currencies. When a currency pair is purchased, the trader is purchasing the base currency and selling the quote currency. When a currency pair is sold, the opposite is true: the trader is buying the quote currency and selling the base currency.

Order Types

Orders are the instructions that traders give brokers to buy or sell currencies. Those orders are usually issued directly to the forex broker through the trading platform.

Various types of orders are used in forex trading. The forex order types will be familiar to traders experienced in equities or futures trading. Three common types of orders are the Market Order, the Limit Order, and the Stop Order.

The Market Order instructs the broker to buy at the current market rate, and in the electronic age, is carried out with the click of the mouse. In the forex market, this order type is usually executed immediately, at the price displayed in the trading platform at the time the order is placed (at the instant of the mouse click). That ability to place orders instantly is in marked contrast to many other markets, when the actual price at which a market order is executed might differ greatly from the price at the time the order is placed.

The Limit Order instructs the forex broker to execute a trade to enter a forex trade at a specific price. The trade could be either to buy currency when (if) it reaches a specific price below the present market price, or to sell the currency pair when (if) it reaches a specific price above the present market price.

For example, consider a trader who wants to buy USD/CAD, thinking that it is likely to increase in value. However, the trader believes that the pair will decrease in value slightly below the present market price before climbing. Since the trader wants to take buy at the lowest possible price, he therefore wishes to wait until the pair reaches the lower price before entering into the trade.

Without a limit order, the trader would need to patiently watch the trading platform, waiting for the price to dip to his target entry price, and then placing a market order.

The limit order automates the process. The limit order can be placed, and the trading platform will wait for the price to drop to target price entered by the trader.

A drawback to using a limit order is that it is only effective at the specific price, and not one pip away. However it does mean that a trader does not have to continually monitor the market waiting prices to meet his entry price.

The Stop Order is similar, but opposite to the Limit order. This order type is normally used to exit an existing forex trade by liquidating a position when the market price changes against the expectations (and position) of the trader. The Stop Order is an order to buy above the present market price, or sell below the present market price. This order is normally used to limit losses if the currency pair price changes unfavorably in a forex position. For that reason, it is also known as a stop-loss order.

Exiting a Position

A trader exits a position, that is, completes the trade, or leaves the market, when he executes the opposite trade by which he started. If he bought USD/CAD he then sells USD/CAD. Note that the trader could also have sold USD/CAD initially, and then bought USD/CAD later to exit the trade and close the position.

Calculating Profit or Loss

Once a trade is completed, profit or loss can be calculated-this is usually done automatically by the trading platform (and most platforms calculate profit and loss continuously throughout a trade. Profit/Loss is the difference between the value of the currency when the trade was entered, and when it was completed (or exited). It is important to understand how profit and loss is calculated, in order to better understand forex trading.

Just as in an auction, a transaction in the foreign exchange market uses the terms Bid and Ask to describe the value of the currency. The Bid is the price at which the currency pair can be sold by a trader, while the Ask is the price at which the currency pair can be bought. In a long trade on a currency pair, profit loss is the difference between the Ask price when the trade is entered, and the Bid price when the trade is exited. Conversely, in a short trade profit/loss is calculated as the difference between the Bid price at the time of entry, and the Ask at the time the trade is exited. An example will help to clarify.

Assume that a trader believes that the Euro will increase in value as compared with the US Dollar. The trader places a market order to buy EUR/USD, and the trade is executed at the (then) current price of 1.3490/93. Since the trader must buy at the Ask price (and this is a Full Size account), the purchase is for 100,000 Euros at the price of $134930 US Dollars.

As the trader hoped, the value of the Euro does in fact, increase relative to the US Dollar. The trader closes the trade by selling EUR/USD, at the market price of 1.3505/08. Since the trader must sell at the Bid price, he sells the EUR/USD for $135050 US Dollars.

The profit on this trade is $120 US Dollars ($135050-134930)

However, if the trade did not work out as well as the trader hoped, and the trade was exited below the entry price, the profit/loss would look much different.

Let's assume that the trade was closed by selling the EUR/USD position when the price was at 1.3484/87. At that price, the 100,000 Euros are sold for $134,840. The trade results in a loss of $90 US Dollars ($134,840-$134,930)

Account Balance, Leverage and Margin

A quick review of leverage and margin might be helpful.

Every trader is required to maintain funds in their trading account with the brokerage. (This deposit is normally held in a segregated fund, in trust - often as regulated by the legal authority under which the brokerage operates, but be sure to check, since requirements vary from authority to authority, and possibly from brokerage to brokerage).

The minimum amount of this account is often set by the brokerage terms. In addition to the established minimum, the account also has a very practical use for margin. In order to enter and maintain a trade, the trader must commit some of the trading account; this amount is called 'margin', and the trading account itself is sometimes referred to as a margin account. The amount of margin committed by the trader for any specific trade is a percentage of the trade value, in a ratio usually called leverage.

Leverage ratios are commonly in the range of 100:1 to 10:1. If the ratio is 100:1, the trader must reserve 1% of the trade value as margin.

For example, consider the trader who enters a full size trade for USD/JPY. That trade has a value of $100,000 US Dollars. If the leverage offered by the broker is 50:1, the trader must maintain and commit 2% of the trade value in his margin account, or $2000. If the USD/JPY trade gains in value, the trader's account balance will increase by the amount of the profit (thus providing additional funds that the trader might use to enter additional trades).

However, if the trade loses funds, even temporarily, the trader must commit additional margin funds to the trade, thus reducing the amount in the margin account that would otherwise be available to commit to other trades. If losses in the trade exceed the balance available in the trader's account the trading platform usually exits the position automatically.