How do you trade forex?
How do you read a forex quote? What is the bid, offer and spread? How do you buy and sell? What is margin and leverage? Calculate profit and loss together with an example trade.
When trading forex you will see pricing tiles like this.
The pair is GBPUSD. When you see rates in GBPUSD it simply means “how many USD does one GBP get me?” The answer to that is the rate displayed. But there are two rates displayed, you say! 1.28297 and 1.28482.
The left-hand rate is referred to as the “bid” and the right-hand rate is referred to as the “offer” — the difference between “bid” and “offer” is the "spread", which we can see is 185 micro pips or 18.5 full pips.
What's a pip?
A lot of folks get confused about pips but they're really simple.
A pip is simply the historical unit in which prices fluctuated on the interbank market. Over the years, as computers have replaced human traders, spreads have tightened and now prices are often quoted to more precision - hence the micro pips.
In GBPUSD (and most pairs) the 4th decimal place is one pip. For example the difference between 1.28485 and 1.28495 is one pip. In USDJPY, however, a pip is defined as the second decimal place. For example 110.225 to 110.235 is one pip.
Don't worry, though, you won't need to remember the peculiarities of each pair: just look at the large characters on any platform. Those are the pips. Looking at the USDCAD example below that is 63 and 69, indicating a spread of six pips.
Often traders will refer to spreads in pips "the spread is half a pip wide" or will talk about trading ranges "USDCAD traded in a 50-pip range today" and this is all you have to know to understand what they mean. It becomes intuitive very quickly as you look at these prices more often.
Selling AKA “giving the bid”
If you wish to sell GBP and buy USD you will do so by hitting the bid. We can see that for each GBP we sell we shall receive 1.28297 USD in return.
You would sell GBPUSD if you think the GBPUSD rate will go down i.e. the GBP loses value versus the USD.
This is often referred to as being “short” GBPUSD. Short GBP and long USD.
Buying AKA “paying the offer”
If you wish to buy GBP and sell USD you will do so by taking the offer. We can see that for each GBP we buy we must provide 1.28482 USD in return.
You would buy GBPUSD if you think the GBPUSD rate will go up i.e. the GBP gains value versus the USD.
This is often referred to as being “long” GBPUSD. Long GBP and short USD.
Why is there a difference between the bid and offer prices? Well, that is the spread that market makers charge.
If you wish to buy, say 1,200 GBPUSD, it is unlikely that another trader wishes to sell 1,200 GBPUSD at that exact time! Up step the market makers with a streaming two-way quote, allowing you to trade either side whenever you like.
When you buy GBP and sell USD to them, they will wait for another trader to sell GBP and buy USD from them to flatten their book. In the mean-time the market for GBPUSD may move higher or lower and so they charge a small spread to compensate for this risk and the cost of running their business.
Margin and leverage
Let us imagine we are trading EURUSD and have a one-day trade horizon. This pair fluctuates on average less than 1% a day.
With an account of £100, I am only likely to make or lose 1% i.e. £1. That is very small. However, leverage allows traders to amplify these moves. Here’s how it works.
- Leverage of 10:1 means that I deposit £100 into my account.
- This £100 is known as the margin.
- The broker then gives me a balance of £1,000 i.e. 10x my margin amount.
- Now when I buy EURUSD and it moves 1% I will be doing so on an account of £1,000 so a 1% move becomes £10 instead of the £1 before.
Relative to my margin balance, I have now made (or lost) 10% on an instrument that only moved 1%.
Leverage is a powerful tool but a double-edged sword. It amplifies not only profits but also losses.
Recently ESMA (a European regulator) has put in place rules to cap the margin offered by brokers to retail clients at 30:1 and furthermore to protect account balances so that traders cannot lose more than they deposit in margin.
This is very sensible as over-use of leverage is a common cause for retail traders to blow up their accounts.
Other jurisdictions such as Australia still allow for leverage of up to 500:1 for retail clients but, just because it is available, does not mean you should use it.
Margin calculators are available online.
An example trade from start to finish with profit and loss calculation
Bob believes GBPUSD will rise on the day.
Bob has a deposit margin of £100 and his broker gives him leverage of 10:1. In real life you should never risk your entire deposit on one trade — this is just to keep the example simple.
This gives him an account balance of £1,000 so he buys £1,000 of GBPUSD at 1.28482.
As the evening approaches, Bob turns out to be wrong. Instead of gaining by 1%, GBPUSD has declined by 0.5% and is now trading at 1.27840 / 1.27923.
Bob sells at the new bid price of 1.27840 and closes out his position. He is now flat.
He has lost 0.5% * £1,000 i.e. £50.
This is taken from his deposit margin and he is now left with £50 as his trading balance.