How Forex Trading Works

So how does the actual trading work? A complete transaction is the buying of one currency and selling of another at the same time. We will be focusing on spot transactions in these lessons. The technical definition for a spot contract is a transaction at the current market rate with a settlement that takes place within two business days. However, in a practical sense, when trading Forex, a position is opened at the current rate and can then be closed any time afterwards, at that next moment's rate. Positions that are not closed within the two business days are automatically "rolled over", meaning the Forex dealer with which the position is open will keep automatically renewing your spot contract for you until it is closed.

Going Long or Short
A long position is a situation in which one purchases a currency pair at a certain price and hopes to sell it later at a higher price. This is also referred to as the notion of "buy low, sell high" in other trading markets. In Forex, when one currency in a pair is rising in value, the other currency is declining, and vice versa. If a trader thinks a currency pair will fall he will sell it and hope to buy it back later at a lower price. This is considered a short position, which is the opposite of a long position.

On every exchange, a trader has a long position on one currency of the pair and a short position on the other currency. A trader defines his or her position as an expression of the first currency of the traded pair. The first currency in a pair is known as the base currency. The second currency in the pair is called the counter currency. When a trader buys the base currency he or she takes a long position on a pair, if a trader sells the base currency he or she shorts the pair. Let’s look at a Forex chart and visualize this idea.

How to Read a Forex Chart

USD/JPY - January 22nd to January 24th

The current exchange rate is shown as a brown line with the pair’s price in a brown box. In the above chart, the current rate (120.93) for the USD/JPY pair is the amount of Yen it takes to exchange for 1 Dollar. Forex notation is a little awkward as the rate is equivalent to how much of the counter currency (second in the pair) is required to exchange for 1 unit of the base currency (first in the pair). Therefore, the notation is upside down from the normal logic of using a fraction. When the value of the base currency, here the Dollar, is rising, the rate will be moving upwards (seen as blue candles). If the rate changes from 120.93 to 121.50, it will take more Yen to buy the same amount of Dollars. When the situation is reversed, the Japanese currency is doing better and the pair's price will fall (seen as red candles). It will take less Yen to buy the same amount of Dollars.

Let’s say the trader buys the Dollar while selling Yen at the current rate of 120.93. The trader is therefore buying or longing the USD/JPY pair. If the trader was to sell the Dollar and buy Yen then he or she would be selling (shorting) the pair. This system of terminology is used in order to avoid confusion about which pair is being bought or sold. By taking a long position on the pair, the trader will wish to sell the Dollar back versus the Yen at a higher price, say 121.50, a change of 57 "points".

What is a pip?
A change in price of one "point" in Forex trading is referred to as a pip, and it is equivalent to the final number in a currency pair’s price. For pairs that involve the Yen (like in our USD/JPY example), a pip is counted from the second decimal place, 120.94. For all pairs that don’t involve the Japanese Yen a pip is the fourth decimal place, 1.3279. For the EUR/USD pair that rate would mean that it takes 1.3279 Dollars to get 1 Euro. The value of a pip will be explained on the next page when we discuss margin and leverage.

More Trading Terminology and the Spread
A bid price is the rate at which the market is prepared to buy a specific currency pair in the Forex trading market. This is the price that a trader will receive when selling (shorting) a currency pair. An ask price is the rate at which the market is ready to sell a particular currency pair. This is the price that a trader will have to pay in order to buy (long) the currency pair. The bid/ask combination comprises a quotation, which is based on a floating exchange rate. The quotation lists the bid price first, then the ask price. For the USD/JPY pair the quote will be 120.93/96.

The disparity between the bid and ask is known as the spread, which reflects the difference between the rate offered by a market maker such as Forex Continent to sell a currency pair and the rate at which the market maker will buy the pair. The value of the spread is greater for currencies that are traded less frequently on the market than for the cluster of the major trading currencies. Contrary to stock market firms, Forex market makers generally do not charge a commission for every transaction, and instead obtain their compensation from the spread.