RETAILL FOREX TRADING

Retail Forex Trading

As previously mentioned, currencies fluctuate relative to other currencies. Take two of the most common currency pairs, the EUR/USD (the price for Euros in US dollars) and the GBP/USD (the price for The Great British Pound in US dollars). If there is positive economic news in the Euro zone and negative economic news in the United Kingdom, it is very conceivable that the EUR/USD would go up in value, meaning it is now more expensive in US dollars to purchase one EUR, and that the GBP/USD would go down in value, meaning it is now cheaper to buy Great British Pounds with US dollars. In this scenario, the US dollar went up in value against one currency and down in relation to another. It is important to understand this idea that currency pairs move mostly independently from one another. Currency pairs with similar currencies on one side (like the USD in the previous example) can be similarly affected by news regarding the common currency, but the crucial concept is that they don’t have to be.

Retail Forex is usually highly leveraged

The idea of margin (leverage) and floating loss is another important trading concept and is perhaps best understood using an example. Most retail Forex market makers permit 100:1 leverage, but also, crucially, require you to have a certain amount of money in your account to protect against a critical loss point. For example, if a $100,000 position is held in Eur/USD on 100:1 leverage, the trader has to put up $1,000 to control the position. However, in the event of a declining value of your positions, Forex market makers, mindful of the fast nature of Forex price swings and the amplifying effect of leverage, typically do not allow their traders to go negative and make up the difference at a later date. In order to make sure the trader does not lose more money than is held in the account, Forex market makers typically employ automatic systems to close out positions when clients run out of margin (the amount of money in their account not tied to a position). If the trader has $2,000 in his account, and he is buying a $100,000 lot of EUR/USD, he has $1,000 of his $2,000 tied up in margin, with $1,000 left to allow his position to fluctuate downward without being closed out.

Typically a trader's trading platform will show him three important numbers associated with his account: his balance, his equity, and his margin remaining. If trader X has two positions: $100,000 long (buy) in EUR/USD, and $100,000 short (sell) in GBP/USD, and he has $10,000 in his account, his positions would look as follows: Because of the 100:1 leverage, it took him $1,000 to control each position. This means that he has used up $2,000 in his margin, out of a $10,000 account, and thus he has $8,000 of margin still available. With this margin, he can either take more positions or keep the margin relatively high to allow his current positions to be maintained in the event of downturns. If the client chooses to open a new position of $100,000, this will again take another $1,000 of his margin, leaving $7,000. He will have used up $3,000 in margin among the three positions. The other way margin will decrease is if the positions he currently has open lose money. If his 3 positions of $100,000 decrease by $5,000 in value (not at all an unusual swing), he now has, of his original $7,000 in margin, only $2,000 left. As discussed above, if you have a $10,000 account and only open one $100,000 position, this has committed only $1,000 of your money plus you must maintain $1,000 in margin. While this leaves $9,000 free in your account, it is possible to lose almost all of it if the position dives. On the other hand, if you have 5 positions open in a $10,000 account, you can lose only $5,000 because the other $5,000 is held in margin. However, this does not make it safer to hold more positions. The Forex market fluctuates so rapidly, that with shallow margins, you are much more likely to be closed out of your position and lose it entirely when it might have recovered from a temporary fluctuation if you had had sufficient margin to cover the variation. The more positions open at one time, the more risk the trader is exposed to.

Transaction costs and market makers

Market makers are well compensated for allowing retail clients to enter the Forex market. They take part or all of the spread in all currency pairs traded. In a common example, EUR/USD, the spread is typically 3 pips (3/100 of a percent). Thus prices are quoted with both a Buy and Sell price (e.g., Buy Eur/USD 1.2000, Sell Eur/USD 1.2003). That difference of 3 pips is the spread and can amount to a significant amount of money. (Note: the spread is only taken out at the beginning of the trade; this transaction cost is subtracted only upon entering the trade, not leaving it) Because the typical standard lot is 100,000 units of the base currency, those 3 pips on EUR/USD translate to $30 paid by the client to the market maker. However, a pip is not always $10. A pip is 1/100th of a percent, and the currency pairs are always purchased by buying 100,000 of the base currency, which is also known as the counter currency. For the pair EUR/USD, the base currency is USD; thus, 1/100th of a percent on a pair with USD as the base currency will always have a pip of $10. If, on the other hand, your currency has Swiss Frank (CHF) as a base instead of USD, then 1/100th of a percent is now worth around $8, because you are buying 100,000 worth of Swiss Franks.

If a trader with a $10,000 account on 100:1 leverage felt, after reading reports on the economy, that the USD was going to go up in value against the EUR and the CHF, he would Sell EUR/USD (thus selling EUR and buying USD) and Buy USD/CHF (buying USD and selling CHF). The transaction is all electronic, so the trader doesn’t need to have Euros in his account. On a large scale, the market maker can sell Euros on behalf of the trader, knowing that the position will eventually be closed and converted back to USD. Assume that the client sold 100,000 EUR/USD at 1.2000 and bought 100,000 USD/CHF at 1.2500. Seconds after this transaction, his account would read: Balance: $10,000, Equity $9,946. The loss of $54 is due to the transaction cost taken only at the entry of a position of 3 pips, which translates to $30 for the EUR/USD pair and $24 for the USD/CHF pair. With equity of $9,946 on 100:1 leverage with 2 positions opened, $2,000 is now held in margin, leaving the trader $7,946 in usable margin. Suppose the EUR/USD (sold at 1.2003) starts to move against the trader and goes up in value to 1.2013, while the USD/CHF (bought at 1.2500) starts moving for the client and also goes up in value to 1.2515. His account information will have changed but his balance and margin will remain unchanged at $10,000 and $2,000 respectively. His equity and his usable margin, however, will change to reflect the new market conditions. While for the trader, the platform will calculate this all automatically, it is important to see it step by step.