Currency trading is a process of speculating on the variation in exchange rates between two currencies. Price (demand price) when purchasing the base currency and selling the base currency Y transaction size = loss or profit. The most important aspect of currency trading is understanding the interplay between price (demand price) and quantity (depth). This is essential for currency traders since price (demand price) will vary over time, while the depths (or size) will vary in response to the economic variables that can affect currency prices.
There are three leverages used by Forex traders to make their trades: Base, Stop-Loss, and Profit and Loss Threshold (PRTH). These are usually thought of as fixed points, where a certain amount of profit or loss is possible. However, since they change depending on how investors react to economic indicators, it is best to understand these leverages in a broader context.
The leverages range between -100 and 100, with the lower limit being the lowest and the higher limit the highest. For example, when you enter the “buy” or “sell” (buy or sell) into a Forex account, your transaction will be completed when the balance reaches the stop-loss, which is typically set at the total profit achieved for that day. As the investor sees the total profit realized through the “sell” command, his or her interest in further transactions is curtailed, and the trader becomes a seller. Consequently, the stop-loss is triggered and the sell-side quote currency rate is converted from the counter currency rate to the original quote currency rate, resulting in a loss of profit.
The stop-loss mechanism is very useful for a Forex trader who has the ability to control his or her investment decisions. Trading on a small profit from the start can be quite profitable; however, if a trader is unable to control his or her investment decisions, the potential for loss of profit may become a reality sooner rather than later. Trading with smaller amounts means that the trader does not risk as much capital. However, if the investment decision is made based on the assumption of achieving more profit than loss over time, it is important to make that assumption a realistic one. By using a quoted rate, the investor is able to determine the initial investment, and in turn can establish a realistic expectation of profits over time.
Many Forex traders prefer to work with brokers offering them either the fixed or the floating types of leverage. Fixed leverages are used when the amount of money being traded is small, and the profit potential is limited only by what can be invested. This type of leverage is most commonly associated with large Forex brokerage firms. Conversely, floating leverages are used when the amount of money being traded is medium to large. Again, this type of leverage is most often associated with FX brokerages offering high-risk ventures.
A common example of a floating leveraged currency is the Eurodollar transaction. The idea here is that the spread is determined by how much one Euro could buy another Euro at the current exchange rate, expressed as a percentage over the transaction size. When the value of the first Euro is greater than that of the second, the broker will provide the Forex trader with a profit of the difference, multiplied by the transaction size. In other words, when the Eurodollar is purchased by a trader, and the Eurodollar is sold by him or her at a profit, the value of the Eurodollar will change. The trader is assuming a certain amount of risk, because without hedging, he or she would have had to sell the Eurodollar in order to purchase the second Euro at the stated exchange rate.
To determine the level of risk involved in the underlying transactions, a quote currency calculator is used. This calculator factors in the present day Euro exchange rate against the selected reference base currency. It then determines the profit target, which is the maximum amount of profit that can be realized. The quote currency calculator can also be used to determine the risk associated with the trade. If the Eurodollar is purchased at the current exchange rate, and the Eurodollar is sold at a higher rate than the present day Euro exchange rate, the trader may incur a loss. Again, the trader is assuming some level of risk, since without hedging, he or she would have had to sell at a loss to cover the difference between the two currencies.
When the Eurodollar is bought at the current Euro exchange rate, and sold back at a higher price than the present day Euro exchange rate, then profit is realized. The more exposure that a trader has to the underlying assets, the larger the potential profit. This form of hedging is called quote currency hedging and is very popular with Euro traders who have a substantial amount of exposure to European securities.