Lesson 5: How to trade Forex
How to trade.
How to read an exchange rate
This is an exchange rate between the Great British Pound and The US Dollar.
All exchange rates, or forex quotes contain a pair of currencies.
The first currency is known as the base currency and this is always “1”.
The second pair on the right hand side is known as the quote or counter currency and is expressed as a number, with five decimal places afterwards.e.g 1: 1.5000 or £1 is worth $1.50
The decimal number for the quote currency tells you how many US dollars you can buy with the one of the base currency. This rate is used when buying and selling the currencies.
Consequently the rate tells you how many USD it will cost to buy one £GBP
The base currency is always the “basis” for each trade. If you buy GBP then you are automatically selling USD and vice-versa.
When buying the base currency:
Using the example of GBP/USD – 1:1.5000
- This means you have to pay $1.5000 to buy £1. (or $1.50)
- Therefore to buy £100 you would pay $150.000 ($150)
- To buy £1000 you would pay $1500.00 ($1500)
- To buy £10,000 you would pay $15000 ($15,000)
When selling the base currency:
Using our example 1:1.50000
- To sell £1 you would receive $1.50000
- To sell £100 you would receive $150.000
- To sell £1000 you would receive $1500.00
- To sell £10,000 you would receive $15000
When to Buy and sell currencies, the basic rule of thumb is this:
You buy the currency pair if the exchange rate of the base currency is going UP and is gaining value against the quote currency.
Consequently you sell the currency pair if the exchange rate is going down or the base currency is losing value against the quote currency.
The long and short of it
The base currency is always the basis of any trade. If you buy GBP/USD then you are buying pounds and selling dollars and vice versa.
Traders tend to buy the pair of currencies if they think the base one is going to gain in value against the other.
Traders tend to sell the pair of currencies if they think the base one is going to lose value against the other.Let’s say the exchange rate between the GBP/USD is 1:$1.50 then I would want the exchange rate to increase to let’s say 1:$1.60. This means the value of my base currency has increased from $1.50 to $1.60. If I were to then sell the base currency now then it is of a higher value than when I bought it and I would get $1.60 in my hands and a 10 cent profit. This is called “going long”, or taking the “long position.”
If the exchange rate was to go down to £1:$1.40 then I would be looking to buy the quote currency and sell the base currency because it is going to cost me less amount of dollars to buy my £1. This is called “going short”.
It’s a bit more complex than this and done with very simple figures, but the principles are still the same: Buy the base currency if it is set to gain value against the quote currency. Sell the base currency if it is set to lose value against the quote currency.
The exchange rate changes constantly and the fluctuations up and down and these determine whether you choose to buy or sell.
So how on earth do I know when to buy and when to sell?
When to buy..and when to sell currencies
We have a pair of currencies, the GBP (£) and the USD ($).
The basic rules for knowing when to buy and sell is governed by these two simple rules
- If you think that the Pound is going to weaken (lose value) against the dollar you would seek to sell the GBP and buy the USD.
- If you think the Pound is going to become stronger against the dollar (rise in value) then you would buy the GBP and sell the US dollar.
The general rule of thumb is if anything is going to cause uncertainty in a country it will lead to a weakening of their particular currency against the others. This will then cause traders to sell its currency and buy its trading pair. Here are a couple of real-life examples and how they may determine whether you buy or sell.
In the 2015 General Election the Tories are voted into power and things carry on as they have done (for better or worse) like they have for the previous five years. This causes stability. Confidence in the GBP is high as there is set to be continued economic growth. Traders on hearing this news may tend to buy British pounds.Alternatively if, in the 2015 General Election, a rainbow coalition is formed led by the Tories, but also made up of Lib Dems, Greens, SNP and UKIP. This new government is looked upon with a great deal of uncertainty around the world, mostly wondering how on earth UKIP and the Greens are ever going to agree on anything! However nobody knows what economic policies are going to be formed over the next five years and how the UK’s economy is going to perform under this new, patchwork government.
This would lead to traders selling the GB pound and buying other currencies, causing the Great British Pound to lose value against the dollar, yen, euro and any other major currencies.
JPY/USDLet’s escape abroad for a bit. The Japanese government announces measures to weaken the Yen in order to protect its exports to America, then you would buy US Dollars and sell the Yen.
In turn a large multi-national Japanese business completely pulls out its operations in America and returns home, converting all of its assets into yen then you would buy the Japanese currency and sell the American one, because the dollar will most certainly weaken against the yen.
These are just two examples of what can happen and how it can affect a trader to buy or sell currencies.
So what causes currencies to strengthen and weaken against each other?
There are many reasons why currencies fluctuate in value against each other. These changes are determined by many different factors from government policy through to natural disasters. An announcement from the US government regarding export policies can see the dollar rise or fall dramatically against other currencies, while a natural disaster in Japan can seriously affect the performance of the yen in the forex market. Part of the skill in trading forex is analysing and predicting how a certain event is going to affect the world’s currencies. Nobody can predict a natural disaster, nor the reaction to a change in government. This is where the gambling aspect of forex trading kicks in. Will the exchange rate go up, or will it go down?
These events of course govern the actions of traders. If a natural disaster hits Japan and there is growing uncertainty surrounding its economy, for obvious reasons it may cause a mass-selling of Japanese yen. This will then have a knock-on effect of it
- All forex quotes are quoted at two prices a bid price and an ask price.
The bid price
- This is the price that your broker is willing to buy the base currency in exchange for the quote currency.
- The ask price
- This is the price your broker will sell the base currency in exchange for the quote currency.
- Because your broker is out to make money (and lots of it like you)