Understanding When to Buy or Sell a Currency Pair

Forex trading involves the endeavor to predict whether one currency will appreciate or depreciate in comparison to another currency. But how do you determine the right time to buy or sell a currency pair?

In the following examples, we'll employ some fundamental analysis to assist us in making decisions regarding buying or selling a specific currency pair.

The dynamics of supply and demand for a currency are influenced by various economic factors that propel currency exchange rates upward or downward. Each currency is associated with a specific country or region. Therefore, forex fundamental analysis centers on evaluating the overall condition of a country's economy, which includes factors such as productivity, employment, manufacturing, international trade, and interest rates.

If you feel like you're back in your economics class or wish you hadn't skipped those lessons, don't worry! We'll delve deeper into fundamental analysis in a later lesson. For now, let's try to grasp the concept.

EUR/USD

In this scenario, the euro is the base currency and serves as the foundation for the buy/sell decision. If you anticipate that the U.S. economy will continue to weaken (a bearish outlook for the U.S. dollar), you would initiate a BUY EUR/USD order. This means you're purchasing euros, expecting their value to rise against the U.S. dollar.

Conversely, if you believe in the strength of the U.S. economy and anticipate the euro's depreciation against the U.S. dollar, you would execute a SELL EUR/USD order. In this case, you're selling euros, anticipating they will decline relative to the U.S. dollar.

USD/JPY

In this example, the U.S. dollar is the base currency, forming the basis for the buy/sell determination. If you think the Japanese government will weaken the yen to boost its export sector, you would place a BUY USD/JPY order. By doing so, you're acquiring U.S. dollars, expecting their value to increase against the Japanese yen.

On the other hand, if you believe Japanese investors are withdrawing their investments from U.S. financial markets and converting their U.S. dollars back into yen, potentially weakening the U.S. dollar, you would execute a SELL USD/JPY order. In this instance, you're selling U.S. dollars, speculating that they will devalue relative to the Japanese yen.

GBP/USD

In this case, the British pound serves as the base currency, forming the foundation for the buy/sell decision. If you believe that the British economy will continue to outperform the U.S. economy in terms of economic growth, you would opt for a BUY GBP/USD order. By doing so, you are acquiring pounds, anticipating their appreciation against the U.S. dollar.

Conversely, if you have the belief that the British economy is slowing down while the American economy remains robust (akin to Chuck Norris), you would initiate a SELL GBP/USD order. This entails selling pounds, speculating that they will depreciate relative to the U.S. dollar.

How to Trade Forex with USD/CHF?

In this example, the U.S. dollar is the base currency, laying the groundwork for the buy/sell decision. If you are of the opinion that the Swiss franc is currently overvalued, you would execute a BUY USD/CHF order. By doing so, you are purchasing U.S. dollars, anticipating their appreciation against the Swiss franc.

However, if you believe that the weakness in the U.S. housing market will adversely affect future economic growth, potentially weakening the U.S. dollar, you would initiate a SELL USD/CHF order. In this case, you are selling U.S. dollars, speculating that they will devalue relative to the Swiss franc.

Trading in "Lots"

Just as you cannot purchase a single egg at the grocery store, buying or selling just 1 euro in forex would be impractical. Therefore, forex transactions typically occur in "lots" consisting of 1,000 units of currency (micro lot), 10,000 units (mini lot), or 100,000 units (standard lot), depending on your broker and the type of account you hold. (We'll delve into the concept of "lots" further in a later lesson.)

Margin Trading

"But I don't have enough money to buy 10,000 euros! Can I still trade?"

Yes, you can! This is where leverage comes into play.

Leverage is the ratio of the transaction size (known as the "position size") to the actual cash (referred to as "trading capital") used for margin. For instance, with 50:1 leverage, which also translates to a 2% margin requirement, you would only need $2,000 in margin to open a position worth $100,000.

Margin trading enables you to open substantial position sizes using only a fraction of the capital typically required. This means you can engage in relatively large transactions with a relatively small initial investment.

Here's a simplified explanation:

• Let's say you believe market signals indicate that the British pound will strengthen against the U.S. dollar.

• You decide to open a standard lot (100,000 units GBP/USD) by buying British pounds, and the margin requirement is set at 2%.

• You patiently await the exchange rate to rise.

• When you purchase one lot (100,000 units) of GBP/USD at a rate of 1.50000, you are effectively buying 100,000 pounds, equivalent to $150,000 (100,000 units of GBP * 1.50000).

• Given the 2% margin requirement, $3,000 from your account is reserved to initiate the trade ($150,000 * 2%).

• Now, with just $3,000, you control 100,000 pounds.

• As your predictions turn out to be correct, you decide to sell, closing the position at 1.50500, resulting in a profit of approximately $500.
  

When you opt to close a position, the initial deposit (margin) is refunded, and your profit or loss is calculated and credited to your account.

Let's revisit the GBP/USD trade example:

• GBP/USD increased by only half a pence, not even a full pence.

• Yet, you made $500!

• How? Because you weren't trading just £1.

• Your position size was £100,000 (or $150,000) when you initiated the trade.

• Remarkably, you didn't need to fund the entire amount.

• Only $3,000 in margin was necessary to enter the trade.

• Turning a $3,000 capital into a $500 profit equates to a 16.67% return, achieved in just twenty minutes!

• That's the power of leveraged trading!

However, it's important to remember that a small margin deposit can result in substantial losses as well as gains. This means that a relatively minor market movement can lead to a proportionally larger change in the size of your profit or loss, which can work both for and against you.

High leverage may seem appealing, but it can also be risky. For example, if you open a forex trading account with a modest deposit of $1,000 and your broker offers 100:1 leverage, you might decide to open a $100,000 EUR/USD position. In this scenario, a mere 100-pip move could deplete your account entirely, reducing it to $0, as a 100-pip movement equates to just €1. Such a small price fluctuation could lead to the loss of your entire account balance in seconds.

Rollover

In forex trading, for positions that are still open at your broker's "cut-off time" (typically 5:00 pm ET), a daily "rollover fee," also referred to as a "swap fee," is applied, which traders either pay or earn based on their open positions.

To avoid earning or paying interest on your positions, ensure that all your positions are closed before 5:00 pm ET, which marks the end of the trading day.

Since every forex trade involves borrowing one currency to purchase another, interest rollover charges are an integral part of forex trading.

Here's how it works:

• Interest is PAID on the currency that is borrowed.
• Interest is EARNED on the currency that is bought.
  

If you are buying a currency with a higher interest rate compared to the one you are borrowing, you will have a positive net interest rate differential (e.g., USD/JPY), resulting in interest earnings.

Conversely, if the interest rate differential is negative, you will be required to make interest payments.

It's important to note that many retail forex brokers adjust their rollover rates based on various factors, such as account leverage and interbank lending rates.

For specific information on your broker's rollover rates and the procedures for crediting or debiting, please consult with them directly.

Below is a table that provides guidance on the interest rate differentials among major currencies:

Central Bank Interest Rates:

These interest rates are employed by the central banking institutions of a country for the purpose of lending short-term funds to the country's commercial banks.

In the future, we will provide you with comprehensive guidance on how you can leverage interest rate differentials to your benefit.