Basics of Forex Trading

Forex Basics

The very basics

First you need to know a little about forex market makers. A market maker publishes two prices: the bid price (lower) and the ask price (higher). The market maker will sell you units of a currency pair at the higher ask price, and will buy units of a currency pair back from you at the lower bid price. They make money by buying units at the bid from one user and selling those units at the ask to another user, pocketing the difference.

The difference between the bid and the ask is called the spread. A narrow spread is good for users. If you buy at the ask (or sell at the bid) you only need the bid (ask) to move upwards (downwards) a little bit before you can sell (buy) back to the market maker to close the position for a profit. The spread will vary over time; the market maker wants to keep it narrow to compete for customers but wide enough to ensure they make money even when the market moves unexpectedly. When the market is stable the spread will be narrow; when the market is volatile the spread will be wide.

When someone refers to the price of a currency pair you can usually infer which price (the bid or the ask) they are referring to from the context. If they’re talking about going long (buying) then they are probably referencing the ask. If they are talking about going short (selling) then they are probably referencing the bid. Broker software usually allows you to plot both at the same time, which visualizes not only the prices by the spread (and thus the market maker’s measure of volatility).

The “market price” or “mark” is the midpoint between the bid and ask. It’s sometimes used when charting prices, since it smoothes out changes in the spread.

The details of where the bid and ask prices come from, how they differ between market makers and from inter-bank rates, and how they are related to but very different from bid/ask spreads on exchange-traded instruments like stocks are all well beyond the scope of this post. (But you should learn it eventually!)

Opening and closing a position

First, burn it into your brain that a long position is opened by buying from the market maker at the ask and closed by selling back to the market maker at the bid, while a short position is opened by selling to the market maker at the bid and closed by buying back from the market maker at the ask.

(Really a short position is a loan from the market maker that you can satisfy with units of currency pairs bought back from them at a later time. But whatever.)

When you open a new position you use one of two types of orders: a market order or a limit order.

A market order tells the market maker to fill your order as soon as your order gets to the front of the queue, no matter what the price is. If it’s a market buy to go long on a pair then the order will be filled at the ask price. If it’s a market sell to go short on a pair then the order will be filled at the bid price. The time it takes your order to get to the front of the queue is usually less than a second, but the price could change pretty dramatically in that second. A market order says “I don’t care what happens to the price between now and then, just fill my order as quickly as possible.”

A limit order goes through the order queue too, but when it reaches the front it tells the market maker to wait to fill your order until an acceptable (to you) price is available. If it’s a limit buy to go long on a pair then you specify the maximum ask price you are willing to pay. If it’s a limit sell to go short on a pair then you specify the minimum bid price you are willing to accept. If the price is already acceptable then the order is filled immediately just like a market order, otherwise it waits until it’s filled or canceled.

When you close a position you can also choose a market order or a limit order. If you have a long position then you can either submit a market sell order or a limit sell order to sell back your units at the bid. If you have a short position then you can either submit a market buy order or a limit buy order to buy back the units you shorted at the ask. These orders work just like orders to open a position, but instead of creating a new position they cancel out your existing position. (Hopefully leaving you with a profit.)

It is possible to submit offsetting orders that don’t actually cancel out one another! For example, a market maker may allow you to submit a market buy order to go long one lot of EUR/USD and then separately submit a market sell order to go short one lot of EUR/USD, and track those two positions separately rather than cancel them out. For this reason an order used to close out a position is sometimes clarified as “to close”, as in “market sell to close”. Most users will close positions by right-clicking the position in their broker’s GUI and click “close” (or something similar); this will automatically submit a market order (buy or sell) to close. Submitting a limit order to close may take more clicks.

Conditional orders to close

When you create an order you can attach conditional orders to close that are only submitted if the bid or ask price moves past a trigger price. You specify the trigger price and the type of order to be submitted when the trigger hits: market or limit. There are four possible combinations, but only three are commonly used.

  • A conditional market order to close a losing position is called a stop-loss order.
  • A conditional limit order to close a losing position is called a stop-limit order.
  • A conditional market order to close a winning position doesn’t have a name and isn’t commonly used.
  • A conditional limit order to close a winning position is called a take-profit order.

Generally the trigger price is compared to the price (bid or ask) that will be used to close the position. For example, a long position is closed by selling at the bid, so the trigger price for a stop-loss on a long position will be compared to the bid. Some market makers will allow you to get fancy and decide which price your trigger is compared to, which may be useful if, for example, your strategy is entirely based on the ask price but you want to use a conditional order to close a long position without worrying about the spread.

Let’s look at the three common conditional orders to close, from simplest to confusing.

Stop-loss orders

A stop-loss order is a conditional market order to close a losing position. The trigger price is set on the losing side of the position. When the bid/ask price passes the trigger price, a new market order is created to close the position. Like any market order, it is filled at whatever the bid/ask price is when the order makes it to the front of the queue.

For a long position the trigger price is less than the original ask price at which the currency pair was bought. A long position is closed by selling at the bid, so the trigger price is usually compared to the bid. When the bid price falls down to the trigger price a new market sell (to close) order is submitted. When it reaches the front of the queue it’s filled at the current bid, offsetting the position.

For a short position the trigger price is greater than the original bid price at which the currency pair was sold short. A short position is closed by buying at the ask, so the trigger price is usually compared to the ask. When the ask price rises up to the trigger price a new market buy (to close) order is submitted. When it reaches the front of the queue it’s filled at the current ask, offsetting the position.

Stop-loss orders are used as a last resort: “If my losses get too big close the position as fast as possible, even if that means closing at a less advantageous price.” It’s not uncommon for the bid/ask price to shoot past the trigger price so quickly that the price at which the position closes is quite a bit worse than the trigger price. On the other hand, it’s also not uncommon for the price to just barely touch the trigger price (triggering the placement of the market order to close) and bounce back, so that the price at which the position closes is better than the target price. (This latter scenario can sometimes make people wonder why the position was closed, since it may appear that the price never reached the trigger.)

Take-profit orders

A take-profit order is a conditional limit order to close a winning position. The trigger price is set on the winning side of the position. When the bid/ask price passes the trigger price, a new limit order is created to close the position. Like any limit order, it is only filled when the bid/ask price is better for the customer than the specified limit price.

The limit price for a take-profit order is usually the same as the trigger price. (Some market makers may allow it to be different.)

For a long position the trigger (and limit) price is greater than the original ask price at which the currency pair was bought. A long position is closed by selling at the bid, so the trigger price is usually compared to the bid. When the bid price rises up to the trigger price a new limit buy (to close) order is submitted. When it reaches the front of the queue it waits until the current bid is at least equal to the limit price, then it fills and offsets the position.

For a short position the trigger (and limit) price is less than the original bid price at which the currency pair was sold short. A short position is closed by buying at the ask, so the trigger price is usually compared to the ask. When the ask price falls down to the trigger price a new limit sell (to close) order is submitted. When it reaches the front of the queue it waits until the current ask is at most equal to the limit price, then it fills and offsets the position.

Since the limit price is usually set equal to the trigger price, and since the bid/ask price doesn’t usually reverse within the short time while the new order (to close) moves through the queue, a take-profit order usually closes almost immediately after being triggered, at a price at or very slightly above the trigger/limit price. However it is possible that the bid/ask price just touched the trigger price and immediately reverses, leaving the limit order (to close) pending on the queue until the price moves favorably again.

Stop-limit orders

Finally we come to the confusing one. A stop-limit order is a conditional limit order to close a losing position. The trigger price is set on the losing side of the position. When the bid/ask price passes the trigger price, a new limit order is created to close the position. Like any limit order, it is only filled when the bid/ask price is better for the customer than the specified limit price.

Unlike a take-profit order, the limit price for a stop-limit order is usually not the same as the trigger price.

For a long position the trigger (and limit) price is less than the original ask price at which the currency pair was bought. A long position is closed by selling at the bid, so the trigger price is usually compared to the bid. When the bid price falls down to the trigger price a new limit sell (to close) order is submitted. When it reaches the front of the queue it waits until the current bid is at least equal to the limit price, then it fills and offsets the position.

For a short position the trigger (and limit) price is greater than the original bid price at which the currency pair was sold short. A short position is closed by buying at the ask, so the trigger price is usually compared to the ask. When the ask price rises up to the trigger price a new limit buy (to close) order is submitted. When it reaches the front of the queue it waits until the current ask is at most equal to the limit price, then it fills and offsets the position.

On first blush this appears to be the opposite of a take-profit order, but it behaves quite differently. Take a long position for example, and consider what happens when the bid price moves quickly down past the trigger and continues to fall. The limit sell order (to close) is submitted but suppose the limit is set close to the trigger price. Since the bid is still falling it’s on the wrong side of the limit price (for the customer) so the limit order won’t fill. A stop-limit order says “If I’m losing money and the price moves to X, try to close my position, but don’t accept anything too much worse than X.”

Because a rapid price movement may pass both the trigger and the limit, the limit needs to be set carefully to give a little “breathing room” for the limit in case of rapid price movement.

Stop-limit orders require careful calculation of triggers and limits to fix risk, or you can end up closing a position early, too late, or not at all!

Final thoughts

I hope you learned something! At the very least, I hope some newbies see that setting stop-losses, stop-limits, and take-profits involves a lot more math and understanding of the mechanics of the market than thinking “this looks like a good place to limit my losses” and clicking the mouse.

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