Summary: Currency Trading Basic Concepts
Thank goodness we finished this lesson; it could turn tedious at times but we finally understood every important aspect of trading the forex markets.
Make sure you clearly understood the following before taking the quiz:
How to calculate the pip value for each currency pair and crosses
The difference between the bid and ask, where do we buy and where do we sell
What is margin and how is it calculated
Why margin can lead to substantial profits, but also substantial losses
What is rollover, when do we pay and when do we collect interest
Ok, we got a few brain feeders this lessons, here are the answers:
Brain Feeder 1
In our example where the trader went long EUR/USD at 1.4530 we were asked the amount of USD we used to buy 234,644 Euros (variable lot size). To get to the answer we simply need to do the following calculation:
234,644 x 1.4530 and this equals to 340937.73,
So we bought 234,644 Euros at US$340937.73
Brain Feeder 2
In the second brain feeder of this lesson, we were asked at what price we bought USD/JPY so that each pip has a value of 10 USD per pip.
We usually calculate the pip value using two variables: how much is one pip worth in the USD/JPY pair (0.01) and the actual quote (i.e. 116.47), in this case however, we already know the pip value which is US$10 and how much is one pip worth and we need to calculate the quote, so the equation would be:
0.01/X = 0.0001, solving for X we get:
0.01/0.0001 = X, and X = 100
So the answer is: in order to get a pip value of US$10 in the USD/JPY, the USD/JPY quote must be 100.00
Brain Feeder 3
In this Brain Feeder we were asked to give a reason why different crosses and currency pairs have different spreads? Wouldn’t it be easier to have the same spreads on all of them?
Because the forex market works just as any other market, remember the example we used on Lesson 1 about the used car markets? Well, the same happens to the Forex market, currency pairs that are traded heavily tend to have the tighter spreads and those that are barely traded have larger spreads. And as a result, those that are heavily traded tend to have smoother moves than those that are barely traded hence, it’s riskier to trade exotics or some crosses than the majors because of their low volume.
Brain Feeder 4
In the 4th Brain Feeder we had to calculate what would had happened to the trader for different levels of leverage with the following details: Trading account of US$4,000, she bought 2 standard lots of EUR/USD at 1.2318 and she had an adverse movement of 113 pips (US$1130 per lot).
What would have happened if she used different leverage levels?
400:1 – At this leverage level, the maintenance margin is US$615.9 (246,360 x 0.25%). So there was enough capital to support the adverse movement.
200:1 – At this leverage level, the maintenance margin is US$1231.8 (246,360 x 0.50%). So she had left 2768.2 to support possible losses and guess what, she made it! The adverse movement accounted for US$2260, so there was enough capital to support the adverse movement.
100:1 – We saw this in the material and she got margin called.
50:1 – She is not able to open such trade as the maintenance margin is larger than what she had in her trading account: Maintenance Margin: US$4927.2 vs. US$4,000 in her trading account.
25:1 – She is not able to open such trade as the maintenance margin is larger than what she had in her trading account: Maintenance Margin: US$9854.4 vs. US$4,000 in her trading account.
Wait a minute… Are you saying using higher leverage levels is actually safer than using lower levels of leverage? No, absolutely not. Higher leverage levels are ALWAYS equivalent to larger risks. Think of it this way, Imagine she had two accounts using 100:1 in one of them and 200:1 in the other. Instead of a 113 pip movement we got a 150 pip movement, so she got margin called on both of them.
In the account she used 200:1 she ended up with US$1,231.8 (the maintenance margin). While in her other account where she used 100:1 she had US$2,463.60 left. So, the larger the leverage used, the more of your “risk capital” is at risk.
Also, yes, margin helps us open larger position with only a fraction of the transaction size and because of the larger transaction size profits are larger, but when the market goes against us, losses are also larger!!! Never forget about this!