Welcome to my Masterclass.
In this lesson you will learn what the foreign exchange market is all about and how we are able to take advantage of the worlds biggest exchange.
Pips, lots, long and short
Ok, so now you know how currencies are paired to indicate the difference in value between them. You also have learnt that this market is so incredibly liquid that there are buyers in sellers lined up at any price point. This results in just small to moderate price fluctuations.
A typical stock can go from $5 to $7 (a 40% increase!) in one day on news. This is unthinkable in the currency market. On very volatile days, price (the exchange rate) might fluctuate 0,50% to 2%.
Since the price of currency pairs fluctuate only pennies on any given day, we log its price with four digits after the comma. The 4th and last digit of the price of a currency pair is called a "PIP", which stands for "Percentage In Point" or "Price Interest Point", or just a POINT as some traders call it as well. It is the lowest possible measuring unit in an exchange rate.
For most currency pairs, a pip is 0.0001, or 1/100th of a percent. For pairs that include the Japanese yen (JPY), a pip is 0.01, or 1 percentage point. Some brokers or charting platforms (such as Tradingview) choose to show prices with one extra decimal place. That fifth (or third, for the yen) decimal place is called a pipette. Don't worry too much on remembering all these exceptions, when entering a trade, the broker's software will do all the thinking for you.
Let me demonstrate the value of a PIP with an example. At this time of writing the EUR/USD exchange rate is: 1.0990. This means that if price would rise 10 pips, the exchange rate would increase to 1.1000. Let's say some important EURO news would come out today, and the Euro would rise in value against the USD. By the end of the day the exchange rate would have risen by 2%. What does this mean in terms of price?
Let's do the math. The current exchange rate is 1.0990 EURO, a 2% increase would increase price to: 1.1210. This an increase of 2,2 cents (and 220 pips) on the exchange rate in one day. This is extremely much for a typical day on EUR/USD.
So how do we make money if price can only make such small movements? The answer is leverage. If you had a $10,000 trading account and you would have used your entire trading account to enter the EUR/USD buy position we just talked about, you would have only gained $200 excluding transaction costs. Your entire trading account would have been locked up on one position. For this reason all FX brokers offer leverage on their trading accounts, ranging from 1:10 to 1:400. This means that for every Dollar you put into your trading account, they will x10 to x400 fold in terms of buying power. Therefore you can take large positions without totally locking up your trading account by taking one or two positions. It will increase your chance to make money, but be ware! It also increases your chance to loose money at the very same rate if not risk-managed correctly.
A standard and acceptable leverage is a 1:50 on a FX account were proper risk-management is being conducted. This means that with your $10,000 account, you can take a $500,000 position in the market. In case of the EUR/USD 2% example earlier, this would have resulted in a win of $10,000. This example is just to showcase how powerful leverage really is. We would NEVER use all of our leveraged capital on any single trade. Ever.
As you will learn in the next chapters, our risk-management only allows us to use 1% of our account balance on any given trade. Referring to our $10,000 trading account and EUR/USD example, we would only risk $100 (1% of $10,000) on any single trade.
You might think to yourself, well 2% profit on a $100 investment is only $2.. this can't be right..? And you are correct, this is not how we participate in the FX market.
Let me demonstrate with a graph of GBP/USD below. The green/blue rectangle represents our risk/reward displaying the entry price, stop-loss price and profit-target. Since this is a 1:1 trade, meaning we risk 1% to make 1%, the entry point is right in the middle of where the blue and green rectangles meet. If price does not move up but moves to the downside of the blue rectangle, we would have lost 1% (stop-loss). If price does move to the upside of the green rectangle we gain 1% (profit-target).
At the time of the entry the price is: 1.21622
The stop-loss price is: 1.21142
The profit-target price is: 1.22102
The difference in price between the entry, stop-loss and the profit target is:
Profit Target: 1.22102 minus Entry: 1.21622 = 0,0048. As you know 1 pip is the 4th digit behind the decimal point. Hence the 0,0048 can be read as 48 pips. Since the stop-loss and profit-target are at equal distance to each other, the stop-loss is also 48 pips away from the entry point.
Of course when trading you don't have to do this math yourself. In our trading platform software - tradingview.com - these values are displayed automatically when setting up your entry (see below).
Ok, so now we know we can take a 48 pip risk position to make a 48 pip gain. When we take into account our previous max risk on any given trade of 1% of our account - which in this example is $100 per trade, we can calculate how much $ we wish to risk per pip.
Whenever you take a trade, your broker-platform will ask you how much risk per pip you wish to take. This is now easily calculated. $100 risk for 48 pips. This means $100/48 = $2,08 per pip. When price moves against us for 48 pips, we risk 48 pips x $2.08 per pip which is exactly $100 or 1% of our $10.000 account.
Forex is traded in specific amounts called "lots". A standard lot is $100,000 worth of base currency. A mini lot is $10,000 worth of base currency. A micro lot is $1,000 worth of base currency.
When entering your position size in your brokers software platform, you might need this information, as some brokers will define the trading size in 'K' which is a micro lot. Later in our masterclass we will teach you how to fill out your broker's order screen. We will teach you how to use some of tradingview's features to fill out your orders easy and flawlessly.
In the example above we bought a EUR/USD position. For most people this is a very straight forward type of entry. You buy an asset in anticipation for it to rise in value. Once the asset has risen in value, you then sell your asset for more than you paid for it, and the difference in price is you profit. Same goes in the FX market. Very straight forward. However it is also possible to enter a sell position on a currency pair that you haven't bought beforehand. How? Let me explain below.
So now you now that when traders buy a currency pair, the price of a currency pair moves up. And when they sell their position, price falls. However we as traders can also sell a currency pair without buying it previously. This is called going 'short'. But how is this possible? How can you sell - say for instance EURUSD - if you have not bought the EURUSD pair to begin with?
Let me explain with an example. Imagine you live with your parents and a friend asks you to come to their party and bring some beers. Since you have not anticipated the invitation and haven't bought any beer, you ask your father if you can lend a crate of his. He agrees if you promise to buy a new crate of beer the next day. Your dad paid $10 for the crate and you agree. The next day you go to the supermarket or liquor store are pleasantly surprised that your dads crate of beer is now on sale for $6. So you buy the crate and give it back to your dad. By lending your dads beer and buying it back one day later, when it was on sale, you've saved or just made $4 (40%).
This is exactly how shorting a currency pair (or stock) works. You don't have to buy the pair to sell it. You lend the position from your broker at a certain price. You expect price to fall, just like with the crate of beer. When price has fallen you buy the position back and hand the position back to you broker. Since you've bought the position at a lower price than what your broker lended it you for, the difference is yours - i.e. your profit.
But why would your broker allow this you might ask? Are they now losing on this trade? The answer is no. As I mentioned before, the currency market is the biggest financial market in the world. There are millions of traders and billions of dollars traded every day. For literally each point in price on every currency pair, there are millions of traders who think price will go up or down. So when you decide to 'lend' the position from you broker, your broker actually has someone else already lined up willing to sell you that position for that price (which you are lending it for) and when you buy the position back at the lower price, your broker has another trader lined up as well. So the broker just does what it does best, connecting buyers and sellers. Of course they make a commission in doing so.
This means that going long (buying) or going short (selling) is equally easy to do. In you brokers platform you just select the currency pair you wish to trade and select of you wish to buy or sell that currency pair. It is that easy. More on how to enter a trade and what such an order window would look like in our chapter on brokers.
This might sound like the broker is losing money on this transaction, but it is not. The broker isn't actually "lending" you the position. Is is merely connecting you to other buyers and sellers thinking price will go in the other direction. This is all quite technical and unimportant for you to know as a trader. Just know that when filling out the order screen in your brokers training software, you can select the "Buy" or "Sell" button. What happens in the background after you've, for instance selected "Sell", is not important. For us as traders it is just as easy to go Short as it is to go Long. We just click "Sell" in stead of "Buy".