In equity markets, sellers are effectively selling their ownership interest in companies in return for cash. In fixed income (debt) it is different as the buyer is loaning the seller money in return for an interest payment.
In the FX market, the buyer is purchasing a currency in return for another one trying to predict either the strengthening of the base currency or the devaluation of the quoted currency.
When we trade in the FX market, we cannot buy a single currency. We have to buy a currency against another, so when a currency is quoted, it is always quoted against another currency. Currencies are traded in fixed contract sizes, specifically called lot sizes, or multiples thereof. The standard lot size is 100,000 units of the base currency.
Many retail trading firms also offer 10,000-unit (mini lot) trading accounts and a few even 1,000-unit (micro lot). The officially quoted rate is a spot price. In a trading market however, currencies are offered for sale at an offering price (the ask price), and traders looking to buy a position seek to do so at their bid price, which is always lower or equal to the asking price. See the example below:
If we are trying to buy EUR/USD, then the action in the market is buying EUR against the USD. EUR/USD is currently trading at 1.1550/52. So when we buy 1mln EUR we are paying the offered price in the market which is US$1,155,200. Now, if the price goes up to 1.1562, and we decide to sell the EUR 1m that we just bought, we will get US$1,156,200 in exchange (1,000,000 * 1.1562) and will have made a profit of US$1,000 (1,155,200 - 1,156,200).
Buy position: If we want to buy USD/JPY, the act is that we are buying dollars and selling the yen. We do that because we believe that the exchange rate will rise and allow us to sell back our dollars for a larger amount of JPY at some point in the future.
Sell position: In the currency market of course, we can profit by entering in the opposite direction as well. So, in essence, if we think that EUR/USD will continue on the downside after the ECB major QE program we can place a short EUR/USD order hoping that that the exchange rate will fall further and will allow us to buy back the euros for less dollars than we originally sold them for.
Example: Short 1 lot EUR/USD ($10/€8.91 per pip)
Let’s suppose that we want to sell EUR/USD which is currently trading at 1.1550 level. There will be two reasons why we should sell the EUR/USD pair.
1. Euro is going to lose power, or devaluate
2. Dollar is going to strengthen and flows will drive to the greenback
If our analysis shows that we should be short on EUR/USD for one or both of the above reasons, we have to pick the correct lot size based on our account, risk management and risk appetite and press sell.
Once we press sell at the 1.12193 point, we expect the pair to go below 1.1200 psychological level.
Once the pair is now down to the 1.11932 level, we close the sell order, with a total profit of 26.1 pips or $261.
In the account above, the minimum trade size is 1k. Therefore, the pip value listed in the advanced dealing rates window is based on a 1k trade size. For the EURUSD, that means every pip is $0.10. So the spread in the image above was 2.6 pips x 0.10 = $0.26 was the transaction cost to get into that trade.
For example, if the EUR/USD falls from 1.1560 to 1.1555, the EUR/USD has lost 5 pips. For the Japanese pairs like USD/JPY we count the second spot after the decimal point. In essence, if USD/JPY goes from 118.30 to 118.40 we consider this as a 10 pip appreciation.
The spread is the difference between the bid and the ask price in the market. During Europe and US market hours spreads in major currency pairs with ECN STP accounts tend to vary from 0.2 to 0.5. However, due to lower liquidity, spreads will be higher after the close of the European and US session.
*Tip: Consider the spread as your cost per trade
A market order is an order to buy or sell, at the current ask or bid price quoted on the market. The buy order may be to initiate a new position or liquidate a previous sell position. The sell order may be to initiate a new position or liquidate a previous buy position.
Here is an example of a market order. The current market price – in this case, for buying US Dollars against the Canadian dollar (Ask price) - is 1.23617 and for selling US Dollars (Bid price) is 1.2361.
Stop-Loss / Limit Orders
Stop-Loss and Limit orders are protective orders that close an open position or future position under certain conditions, namely price.
Stop-Loss Orders are used to limit trader's losses if the market moves against their position. The trader sets the maximum amount (in terms of pips) that he is willing to lose on a certain trade. When that specified price is reached, the trade is executed. Conversely, Limit Orders are used to lock in the trader's profit if the market moves favourably. The trader sets in advance the price at which he wants to close his position.
In the example below, a trade was opened at the market price of 1.2365(buying order). According to the stop-loss order, the position will be closed if and when the price falls to 1.2300. According to the take-profit order, the position will be closed if and when the price hits 1.2400.
These types of orders open a new position only if the market reaches a price specified by the trader. Entry orders are divided into two varieties: Entry Limit Orders and Entry Stop Orders.
- Entry Limit Orders – Entry limit orders are orders that are placed by traders to enter the market at a more favourable price than the current price. When Buying a currency pair or a CFD, Entry Limit order will be placed below the current market price. When Selling, a limit entry order will be placed above the current market price.
When placing Entry Limit Orders, the trader expects that the market price will bounce back after reaching the level at which the entry limit order was placed.
For example: The USD/CAD trades at 1.23649/1.23656. Here, you expect the pair to trend higher, but prefer going long at a better price – you expect the price to go down to 1.2350 before it continues going up. You then place an entry limit buy order of 1 lot (5,000 USD/CAD) at 1.2350. When the rate reaches 1.2350, the limit order will be executed and 1 lot of USD/CAD will be bought at 1.2350.
*Good till cancel: An order to buy or sell a security at a set price that is active until the investor decides to cancel it or the trade is executed. If an order does not have a good-'til-canceled instruction then the order will expire at the end of the trading day the order was placed.
- Entry Stop Orders – Entry stop orders are orders that are being placed by traders to enter the market at a less favourable price than the current price. A BUY Entry Stop order will be placed above the current market price. While A SELL Entry Stop order will be placed below the current market price.
When placing Entry Stop Orders, the trader expects that once the market's momentum breaks through the specified price, the trend's movement is confirmed and will continue in that direction.
For example: The EUR/USD trades at 1.1430/1.1431. You estimate that the EUR/USD will continue trending higher. You also believe that should the pair break above 1.1500, it will rise by at least 50 pips. Thus, you place your BUY entry stop order of 1 lot (100,000) EUR/USD at 1.1500.