What Are Forex Transactions?
Foreign exchange, or Forex, transactions involve the buying of one currency and the simultaneous sale of another. The two currencies make up a currency pair, the basic unit traded in the Forex market. To know how to make Forex trades, an investor must thoroughly understand currency pair pricing and transaction entry and exit. For this article, examples are based on the EUR/USD currency pair--the rate of exchange between euros and U.S. dollars.
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Pricing
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The numerator of a currency pair price ratio is called the base currency--the euro in this example. The value of the numerator is always 1. The denominator, or counter currency, represents how many units can be purchased or sold for 1 unit of the base currency. In this example, a price of 1.3500 reveals that 1 euro is worth $1.35. Notice that the price is precisely expressed to four decimal places--this is called pip pricing, for "percentage in point." The bid/ask spread on the EUR/USD is typically 1 to 6 pips, depending on trading conditions.
Long Transactions
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The buyer of a currency pair is called the long position. The long position is, in effect, buying the base currency and selling the counter currency. A long position benefits when the counter currency weakens, that is, 1 unit of base currency buys more units of counter currency. A long entry transaction specifies how many lots--a regular Forex lot is worth $100,000--of the currency pair a trader wants to buy at a particular price, called the bid. The trader's brokerage firm will either sell the currency pair directly to the trader from its own inventory, or it will find a seller who will accept the bid price. To close out a position, the trader places a sell order with a specific ask price.
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Short Transactions
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The short side of the example Forex transaction sells the currency pair to the buyer. Hence, the short position is selling the base currency and buying the counter currency--and benefits from a strengthening of the latter. The seller offers an ask price; if the buyer's bid matches the seller's ask, the transaction will execute. To unwind a short position, a trader will eventually buy back the currency pair at, hopefully for the trader, a lower price than that of the original sale.
Online Trade Execution
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To open a position, prudent traders place three orders simultaneously: entry, take-profit and stop loss. The entry order may be a market order--it is executed immediately at the current price--or a limit order, which represents the long's maximum bid and the short's minimum ask. A take-profit order unwinds a position at a gain. For example, if a successful long trader had entered the market at 1.3500 with a take-profit order at 1.3515, he or she would have made a profit of 15 pips, or 0.0015 percent of $100,000--that is, $150. The stop-loss order declares the maximum amount a trader is willing to lose before closing out a position. If the currency pair market price reaches the stop-loss level, the trader's position is unwound through a sell transaction (for the long) or a buy transaction (for the short).
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