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How does forex trading work?

When you open a forex position, you are buying one currency while simultaneously selling another. Read on for a detailed look at how a forex trade works: including currency pairs, the spread, pips and leverage.

1. Currency pairs

Forex trading always involves selling one currency in order to buy another. For this reason, they are quoted in pairs that show which currency is being bought and which is being sold. Each currency in the pair is listed in the form of its three letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself.

GBP/USD, for instance, is a currency pair that involves the Great British pound and the US dollar. In this pair, you are buying pound sterling by selling US dollars.

Base and quote currency

The first currency listed in a forex pair is called the base currency, and the second currency is called the quote currency. The price of a forex pair is how much one unit of the base currency is worth in the quote currency.

So in the above example, GBP is the base currency and USD is the quote currency. If GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.

If the pound rises against the dollar, then a single pound will be worth more dollars and the pair’s price will increase. If it drops, the pair’s price will decrease. So if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (going long). If you think it will weaken, you can sell the pair (going short). 

2. The spread

The spread is the difference between the buy and sell prices quoted for a forex pair.

Like many financial markets, when you open a forex position you’ll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.

Find out more about the spread.

3. Pips

When a forex pair increases or decreases in price, that movement is measured in units called pips. A pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35471, then it has moved a single pip.

The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip.

The decimal places shown after the pip are called fractional pips, or sometimes pipettes.

Leverage allows you to get exposure to large amounts of currency without having to commit too much capital.

A single pip is a very small unit of movement, and while forex pairs tend to be very volatile they often move in relatively minor increments. For this reason, forex traders will either have to trade large batches known as lots, or take advantage of leverage.

A standard lot is 100,000 units of currency. Alternatively, you can sometimes trade mini lots and micro lots, worth 10,000 and 1,000 units respectively.

Individual traders don’t necessarily have 100,000 pounds, dollars or euros to place on every trade, so many forex trading providers offer leveraged trading. Leverage allows you to open a position without have to pay its full value upfront. A trade on EUR/GBP, for instance, might only require 2% of the total value of the position to be paid in order for it to be opened.

When you close a leveraged position, the profit or loss is based on the full size of the trade. While that does offer a chance of higher profits, it also brings the risk of amplified losses: including losses that can exceed your deposits. 

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