The mechanics of how to make money trading Forex are pretty simple. It’s finding the profitable trades that is the difficult part. But let’s talk about the mechanics a bit here.
It’s really easy to take a position in the foreign exchange market. It’s not unlike taking a position in any other financial market — like the stock market. In currency trading, a trader exchanges one currency for another, expecting to profit off of slight price changes.
Specifically, traders are speculating that the currency they bought will increase in value against the one they sold. Take a look at this example:
You BUY 100,000 British Pounds at a GBP/USD exchange rate of 1.3500.
YOUR HOLDINGS: +£100,000 and -$135,000
A month later, you SELL (or trade back) your 100,000 British Pounds back into U.S. dollars at an exchange rate of 1.4500.
YOUR HOLDINGS: -£100,000 and +$145,000
You take a profit of $10,000.
As a reminder, the term exchange rate is the ratio of one currency valued against another currency. For instance, the EUR/JPY exchange rate tells us how many Euros can purchase one Japanese Yen, or conversely how many Japanese Yen you need to buy one Euro.
Reading Forex Quotes
As we have said, exchange rates are always quoted in pairs, like AUS/USD or GBP/USD. They’re always quoted in pairs because in every transaction a trader is simultaneously buying one currency and selling another.
How does a trader know which currency they are buying and which they are selling though?
For that, we have to take a look at the syntax of a currency pair quote.
Base and Quote Currency
Since currencies are quoted in relation to one another, you will always see a pair quoted like the following exchange rate between the New Zealand dollar and the US dollar.
The currency listed first and to the left is known as the base currency (in this instance, the New Zealand dollar). The base currency is the reference in the currency pair. It always has a value of one.
The currency listed on the right is called the counter currency or sometimes the quote currency (in this example, the US dollar).
So, as you read a currency pair quote, the prevailing price listed — in this case, 1.34556 — means that is how many units of the quote currency you need to buy one unit of the base currency. Following the example, you have to pay 1.34556 U.S. dollars to buy one New Zealand dollar.
And that means that the reciprocal is true, as well. The base currency tells us how much of the quote currency we need to get one unit of the base currency. If you buy USD/JPY, that indicates that you are actually buying the base currency, and at the same time selling the quote or counter currency.
A trader would buy the pair if they were speculating that the base currency will gain value (appreciate) compared to the quote currency.
A trader would sell the pair if they were speculating that the base currency will lose value (depreciate) compared to the quote currency.
There are lots of currency pairs to trade. Who decided which currency is going to be the base currency in which should be the quote currency? Fortunately for you and the rest of us traders, currency pairs are standardized in their notation. You will see currency pairs quoted the same no matter which broker you use. EUR/USD will always be EUR/USD and never USD/EUR unless you toggle a checkbox somewhere and intentionally reverse them for some sort of analysis.
Sometimes there is a slash in between the two pairs and sometimes the slash is omitted. You might see currency pairs listed as EUR/USD, EUR-USD or EURUSD. It’s all the same.
Long and Short
Trading currency is, in many ways, a binary choice. A trader is either buying or selling the pair. If a trader wants to buy the pair — which means buy the base currency and sell the quote currency — they are speculating that the base currency will rise in value, thus allowing the trader to sell it back at a greater price.
This is referred to as going long or taking a long position. All you have to remember is that LONG EQUALS BUY.
If a trader is selling — which means they are selling the base currency and buying the quote currency — they are speculating that the base currency will fall in value, and they would be looking to buy it back at a lower price.
This is called going short or taking a short position. All you have to know is that SHORT EQUALS SELL.
Flat or Square
If you have no open positions, then you are flat or square. Squaring up is a reference to closing a position or all of your positions.
The Bid, Ask, and Spread
As you look at a pair on the screen of your broker platform, you’ll notice that there are two prices: the bid and ask. Generally speaking, the bid is lower than the ask
The price at which your broker is willing to buy the base currency in exchange for the quote currency is called the bid. It is the best price prevailing in the market at which the trader can sell to the market. If you want to sell a currency, the broker will buy it from you at the bid price.
The price at which your broker will sell the base currency in exchange for the quote currency is called the ask. The ask price is the best price prevailing at which you can buy from the market. It’s also called the offer price. If you want to buy a currency, your broker will sell or offer it to you at the prevailing ask price.
What is the Spread?
The spread is how brokers make their money. It is the difference between the bid and the ask price. On the GBP/EUR quote above, the bid price is 1.15891 and the ask price is 1.15911.
- If you want to sell GBP, you click sell and you will sell GBP at 1.15891.
- If you want to buy GBP, you click buy and you will buy GBP at 1.15911.
Here’s a handy reference to reading pair quotes.