Forex trading is aimed at making money on currency speculations. We have been describing the currency market above but avoided such topics as what starting capital is needed to work on Forex and what profit can be expected. In this chapter we will try to make it clear.
As the currency exchange in the exchange office is a simplified model of yielding a profit on Forex, we will start with its description. Theoretically, you can gain profit through buying or selling currency in the exchange office but in this case its amount is too small, as compared to the opportunities of making money online on Forex.
So, imagine that you have $1,000 and want to earn on currency speculations in the exchange office. Assume that the US dollar versus the Japanese yen is quoted at 104.15/106.65 in the exchange office. We forecast the increase of the Japanese yen versus the U.S. dollar, and hence, decide to buy the yen for all our dollars. From the preceding chapters we know that ask and bid prices are related to the base currency of the pair, in our case it is to the US dollar. Thus, we are selling the dollars, which are then bought by the exchange office. The rate of buying or bid, is shown first in the quote. Thus, we get 104.15 * 1,000 = 104,150 JPY.
If we sell our yens for the US dollars immediately, according to the given quote, we will receive 104,150 / 106.65 = 976.56 USD. That means we will have losses at this operation, equal to $1,000 – $976.65 = $23.35. So what is needed to get profit? It is obvious that we need the ask price in the quoting USD/JPY to fall lower, than the initial buy price, that is, the bid price should fall by more than 250 pips. Note that 250 is the size of the quoting spread, that is, the ask price should change at least by the size of the spread, so that we could at least get back our $1,000. The problem is that we can wait long enough (weeks, months) for the change of the currency rate by 250 pips, depending on the current situation on Forex. But imagine that the rate after all has changed for 500 pips in the favourable direction; that means the quoting is USD/JPY 99.15/101.65. What profit will we gain after selling our Japanese yens? We will get 104,150 / 101.65 = $1,024.59 . Thus, our net profit from the operation will be $1,024.59 – $1,000 = $24.59. In reality, one can wait too long for the currency rate to change by 500 points. That means, $24.59 can become our month or even quarter profit. Naturally, it is not the profit we would like to gain. But you can relax, as working on Forex is completely different!
From the previous example we have learned the valuable information, that the lower the spread volume of the quoting is, the more profitable it is for traders. In the exchange offices the spread can equal to hundreds of ticks, and the quoting, as a rule, is only changed once in 24 hours. On Forex, the size of the spread depends on the party, which sets the quoting. For a private investor, who is working online the spread volume is set by his online broker (the brokerage house). Therefore, it is important to choose the broker, which offers the most favourable trading conditions. Depending on the currency pairs, the spread volume usually varies from 1 to 10 pips. But as it was stated above, when the currency market is unstable, online brokers are acting accordingly.
Another lesson learnt from the previous example is that for turning profit from currency rate speculations in the exchange office, it is necessary to buy currency in order to make a reverse operation in due time, that is to sell it. Besides, in the example with the exchange point, in order to buy the Japanese yens for the US dollars we need to have the whole sum in dollars. This is vivid, of course, but on Forex everything is easier, and this will be commented on further. One more thing which we should pay attention to is that for currency speculations we can use only the funds, which we have in cash. Of course, nobody prevents us from taking a bank credit, but no bank will give you a credit for speculations on the currency exchange. Moreover, you would not like to lose the most part of your credit on such speculations and get into debt, would you? With Forex, everything is simpler. Using the principle of margin trading, which will be discussed in the next chapter, and having comparatively inconsiderable funds (even a few thousands of the U.S. dollars), we can control the capital, which by hundred times exceeds our own funds. The bigger capital we manage, the higher can be the profit. If we bought the Japanese yens not for $1,000, but for, let us say, $100,000 we would gain not $24.59 but the entire $2,459 and this makes it worth continuing Forex education, doesn’t it? Hence, let us finish the discussion of the exchange office and pass to the forex exchange market.
In order to work on Forex online, you should choose the broker. The broker opens an account for you, in which you deposit a certain sum of money, called the security deposit. The amount of the security deposit is a philosophical and, at the same time, a practical question. It depends on how aggressive you are going to trade, and on the leverage (it will be discussed in the next chapter), which you will use, on how many lots (it will be discussed later) you open at the same time, and what experience of Forex trading you have, etc. For a novice, it is recommended to have not less than $1,500-2,000 on the security deposit. The security deposit, as a rule, is kept on special multi-currency accounts, which the broker opens for you in the bank. Generally, the majority of brokers are foreign corporations, registered off-shore. For this reason, the accounts are opened in the US dollars, but this (unlike in the example with an exchange office) does not mean that you will be able to work only with the dollar quotes. To buy the Japanese yens for pounds, a trader does not need to have pounds on his account. The advantage of Forex market is the possibility to earn on the currency rates without real currency supply, i.e. the date of the currency valuation loses its significance. Having the US dollars on the security deposit, we can make deals in any other currency. Let us remind you about the example with the exchange office, where we were waiting for growth of the Japanese yen rate versus the US dollar, in other words, for the moment when the dollar will fall versus the yen in the quote USD/JPY. And what if we were on the contrary, waiting for the uprise of the dollar rate vs. the yen? It would be more logical to buy the U.S. dollars for the Japanese yens, but what should we do if we have only $1,000 and no yens? Naturally, we would not be able to make such an operation in the exchange office. Thus, working on Forex, a trader is able to make such deals, since there is no real support of the currency (as we have already mentioned), the money is gained only on speculations, and the profit is converted into the currency of the security deposit, i.e. into the US dollars.
The principle of yielding is the same: to make an operation, we should first buy the currency at a lower price in order to sell it at a higher price later on. Firstly, sell the currency at a higher price, in order to buy it later at a lower price, which is almost the same. This is due to the fact that one type of the currency is always bought or sold for another type. The first operation stage on Forex is called the opening of the position. The second one is called the closure of the position. At the moment of the position closing, the profit or loss from the deal is calculated, which is either added to or charged from the security account correspondingly. You can open the deal by placing a buy/sell order of the base quote currency. If you open a Buy position, it is called a long position. If you open a Sell position, it is called a short position. When, for instance, you hear a phrase “I have an open long position on the US dollar vs. the Japanese yen”, it means that expecting the rise of the US dollar rate versus the Japanese yen, a purchase of a certain amount of dollars for yens was made.
The minimal volume of the operation on Forex is called a lot. Its size is depicted in the quoted currency, but as a rule, is equal to $100,000. Working on the currency market, you open and close positions, the size of which is always equal to a whole number of lots. The question that may have arisen is how a private investor can work on Forex, if the minimal sum of the deal is so high. The principle of margin trading, which will be discussed in the next chapter, will let you manage the funds equal to $100,000 having only some thousands of dollars on your security deposit and risking your deposit only.
But even the margin trading principle cannot save those who do not have such amounts. Anyone having a relatively small capital (around $1,000) is free to trade on Forex as well. For such investors brokers introduce mini lots equal to $10,000. And some brokers even offer micro lots, equal only to $1,000, and to control it one needs only a few hundreds of dollars, but these lots are used rather rarely. In practice, being a novice trader, you are most likely to trade mini-lots.
It should be noted that the higher your security deposit is, the more lots you can have, opened simultaneously on Forex. As depending on the strategy, which is worked out by every trader, you may need a number of simultaneously opened positions, and this should be taken into account when placing trades. Therefore, you should always control the amount of your security deposit.
What is the approximate profit from one operation on Forex? Imagine that we are dwelling with mini lots, the security deposit amounts to $1,000; we are forecasting the increase of the US dollar rate versus the Japanese yen at the current quotation of the USD/JPY 104.75/80. As we can see, the spread is equal to 5 points, which is typical of Forex and considerably less, than in the example with the exchange office. Assume that we are opening a long position on the USD/JPY with one mini lot at the quotation of 104.80 JPY for one dollar. Our forecast of the rate movement confirms, and at the moment of the position closure the rate is USD/JPY 105.10/15. So, we have managed to "catch" the profitable rate movement equal to 105.10 – 104.80 = 30 ticks. It should be noted that the ticks correspond to the quoted currency, i.e. the Japanese yen. In order to calculate the value of our profit in the US dollars, it is necessary to convert 30 ticks in the dollar equivalent and multiply by the size of the mini lot 10,000. To convert pips to the dollar equivalent we divide 0.30 by the rate of the US dollar selling for the Japanese yens, that is 0.30 / 105.15 = 0.0029. The received value corresponds to 29 points in the dollar equivalent, and multiplying it by 10,000, we can receive the sum of our profit - $29. The rate movement in our example was equal only to 30 ticks, and on this movement with $1,000 we have managed to get profit amounting to $29. Actually, this movement can be "caught" on Forex within a few hours or even minutes.
To summarize the chapter, let us compare the profit, received from the operation in the exchange office described in the beginning of the chapter and the operation on Forex discussed at the end. It is evident that the opportunities which Forex provides cannot be compared to those of the exchange office. The profit which can theoretically be gained within a month in the exchange office can be achieved within an hour on Forex!