How Forex Trading Works

By: nofieiman
Forex, as you very well know, is the largest financial market in the world. Unlike many other markets, the international forex market is open 24 hours a day. Its daily turnover is well over US$ 1.2 trillion. This turnover is more than the combined turnover of the world's major stock markets on any given day. Hence, the international forex market is a very liquid, and thus, a desirable market for trading. As with any other market, technology has also contributed immensely towards its expansion. Now trades are executed increasingly through the internet. It has allowed even smaller investors the access to the market.

In this market you may buy or sell currencies. The objective is to earn a profit from your position. Placing a trade in the foreign exchange market is simple: the mechanics of a trade are virtually identical to those found in other markets, so the transition for many traders is often seamless.

Here are an example of how forex trading works. Say, a trader purchases 10,000 euros in the beginning of 2004 at the EUR/USD rate was .9600. In May of 2006 the trader exchanges his 10,000 euro back into US dollar at the market rate of 1.1800. In this example, the trader earned a gross profit of $2,200.

Currencies are quoted in pairs, such as EUR/USD or USD/JPY. The first listed currency is known as the base currency, while the second is called the counter or quote currency. The base currency is the "basis" for the buy or the sell. For example, if you BUY EUR/USD you have bought euros (simultaneously sold dollars). You would do so in expectation that the euro will appreciate (go up) relative to the US dollar.

Buying/Selling

First, the trader should determine whether they want to buy or sell. If they want to enter a short order - whereby they will profit if the exchange rate falls - they simply need to click on the SELL rate. The opposite holds true for traders who enter buy orders: they can simply click on the BUY rate, and thus will profit if the exchange rate goes up.

Just like in all markets, there are two prices for every currency pair. The difference between these two prices is the spread, or the cost of the trade.

Margin

The margin deposit is not a down payment on a purchase of equity, as many perceive margins to be in the stock markets. Rather, the margin is a performance bond, or good faith deposit, to ensure against trading losses. The margin requirement allows traders to hold a position much larger than the account value.

In the event that funds in the account fall below margin requirements, the forex broker will close some or all open positions. This prevents clients' accounts from falling into a negative balance, even in a highly volatile, fast moving market.

Example of How Margin Works

Since the trader opened 1 lot of the EUR/USD, his margin requirement or Used Margin is $1000. Usable Margin is the funds available to open new positions or sustain trading losses. If the equity (the value of his account) falls below his Used Margin due to trading losses, his position will automatically be closed. As a result, the trader can never lose more than he/she deposits.

Rollover

For positions open at 5pm EST, there is a daily rollover interest rate that a trader either pays or earns, depending on your established margin and position in the market. If you do not want to earn or pay interest on your positions, simply make sure it is closed at 5pm EST, the established end of the market day.

Since every currency trade involves borrowing one currency to buy another, interest rollover charges are an inherent part of forex trading. Interest is paid on the currency that is borrowed, and earned on the one that is purchased. If a client is buying a currency with a higher interest rate than the one he/she is borrowing, the net differential will be positive - and the client will earn funds as a result. Please note that clients must be on 2% margin in order to earn funds.
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