Forex, how it works and what’s important nowadays?
More and more private traders are starting trading Forex and there are some good reasons for that. On one hand, one can start trading in forex market with low capital investment, and on the other hand, the trading volume in this highly liquid market is almost infinitely scalable upwards. Thus, both trading positions of a few thousand dollars and a million dollar trades are easily possible. However, forex trader always has to use only a fraction of the traded capital to trade these positions.
Currency rates, pips, lots, and margin
The exchange rates are calculated and traded exactly to four/five decimal places. The so-called pips are the smallest tradeable unit. For example, if price of currency pair EUR/USD is 1.2225 and the price falls to 1.2200, this is called a price drop of 25 pips.
A lot is the standard unit in forex trading, whereby a lot always comprises 100,000 units of a base currency – in the case of the currency pair EUR/USD, one lot therefore is equal to 100,000 Euros. In addition to lots, many forex brokers also offer trading in mini lots (10,000 units of a base currency) and micro lots (1,000 units.) If a broker offers the trading of micro-lots with low margin requirements, theoretically a few dollars are enough to start trading.
Use and effect of the leverage
In forex trading, in contrast to stock trading, only a small amount of capital is needed. All you have to do is deposit the so-called margin, in order to open a currency position. Depending on the broker, the margin is often only 0.25 to 5 percent of the trading volume, so that, for example, for a micro-lot in EUR/USD with a trading volume of $10,000, can be opened with only $20; the actual amount you need depends on how much leverage you are using. Some brokers even offer a 1:2000 leverage!
The remainder of the transaction volume is virtually leveraged by the broker, which can result in financing costs, such as holding a position overnight or over the weekend. Financing costs must be taken into account, especially for long-term trading positions.
The low equity ratio ensures the creation of an immense leverage effect, since participation in a high transaction value is achieved with little capital investment. This offers the opportunity to record high relative gains as well as losses related to the basic bet. Theoretically, it could also happen that the collateral is no longer sufficient to cover the losses incurred, which would result in an obligation to make additional payments or even a subsequent claim by the broker if the losses cannot be covered by the trading account.
With a margin requirement of 1 percent, for example, with a capital investment of only 100 dollars, a trading volume of 10,000 dollars can be used, whereby only 1% of the transaction volume is bound by the trading account. However, one participates in the ratio 1:1 in both the profit, as well as the loss related to the total trading volume in the amount of $10,000, which creates the leverage effect.
For example, if the currency position loses 1% of its value (this equates to 100 pips,) the margin on a long trade (buy or bet on rising prices) is already used up. As a result, theoretically, the total loss of capital employed as well as further losses is possible. However, in practice, forex brokers usually protect themselves and their clients from the point that a position is automatically closed at the latest when the collateral has been used up.
However, if the forex position gains 1% in value in the same example, the trader would have already doubled the invested capital of $100, thus achieving 100% return in relation to the capital investment!
In any case, traders should prevent losses by appropriate risk management that it never comes to the point of total loss of the invested capital. This can be done in a simple way by using stops and a good trading strategy.