What is Forex Trading? (Part 2)

(Continue Part 1)

An Example of Leverage CFD Trading

Suppose you want to trade CFDs, where the underlying asset is the AUD/USD currency pair, also known as the “Aussie.” Let us suppose that the AUD/USD pair is trading at:

Bid/Ask Spread

Now, “bid” is the selling price. This is what you sell the asset at. The higher of the two is the “ask price” or buy price; the rate at which you buy the asset. The difference between these two prices is the “spread.” This is your cost of trading. Depending on how liquid your asset is and your choice of broker, the spread can be tight or wide. For instance, a broker can source quotes from a large pool of liquidity providers to offer you the tightest bid/ask spreads.

You decide to buy AUD 20,000 worth of USD because you think that the AUD/USD price will rise in the future. Your account leverage is set to 100:1. This means that you need to deposit 1% of the total position value into your margin account.	Now, in the next hour, if the price moves to 0.6880/0.6882, you have a winning trade. You could close your position by selling at the current price of USD 0.6880.

In this case, the price moved in your favour. But, had the price declined instead, moving against your prediction, you could have made a loss. If that loss resulted in your account equity falling below your margin requirements, your broker may issue a margin call.

Notice how a small difference in price can offer opportunities to trade? This small difference is known as “pip” or “percentage in point.” In the forex market, like in the above example, it is used to denote the smallest price increment in the price of a currency. For assets like the AUD/USD, which include the US Dollar, a pip is represented up to the 4th decimal place. But, in case of pairs that include the Japanese Yen, like the AUD/JPY, the quote is usually up to 3 decimal places.

This continuous evaluation of price movements and resultant profit/loss happens daily. Accordingly, it leads to a net return (positive/negative) on your initial margin. In case your initial margin is lower, the broker will issue a margin call. If you fail to deposit the money, the contract will be closed at the current market price. This process is known as “marking to market.”

Forex Quotes/ Exchange Rates

Currencies are traded in pairs, like the Euro/US Dollar (EUR/USD) or Australian Dollar/US Dollar (AUD/USD). Currencies are denoted in 3-lettered ISO codes, such as EUR (Euro), GBP (Great British Pound) and USD (US Dollar). When you see a currency quote, the first currency is called the base currency and the second currency is the quote currency or counter currency. For instance, say the EUR/USD is trading at 1.1086. This means to buy 1 unit of Euro, you will need $1.1086. USD.

The higher price $1.1087 is the ask rate, while $1.1086 is the bid rate. The bid price is the maximum price, a buyer is willing to pay for the currency. Ask price is the minimum price, a seller is willing to accept for the same currency. These rates fluctuate constantly, depending on supply and demand, market sentiment and external events.

Spread

The difference between these two rates is known as the spread. This includes the broker’s charges. The spread depends on your choice of currency pair and the forex broker. Licensed forex brokers who provide ECN (Electronic Communications Network) pricing can source price quotes from multiple liquidity providers in the market. This means they can offer the tightest spreads.

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Read What is Forex Trading? (Part 3)

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