In Online Trading, there is always a simultaneous purchase of one currency and the sale of another. The product in a currency pair is the base currency, denoted on the left side. Traders always buy or sell the base currency.
Conversely, the counter currency is the means of payment, denoted on the right side of the pair.This means that in a trade involving EUR/USD, traders buy or sell the Euro against the USD and the exchange rate is the price of one unit of the base currency in terms of the counter currency.
When opening a transaction for a currency pair, most brokers will allow traders to perform trades in sums of money larger than they have in their account. This is the principle of leverage, expressed as a ratio such as 100:1.
For example, if you have $500 in your trading account and the exchange rate of the British Pound against the US Dollar is 1.248. You believe the price of the British Pound will rise. Leverage allows you to log in to your account and buy 50,000 British Pounds despite the fact that you only have $500.
In this case, 50,000 British Pounds cost $ 62,400 and you would be taking advantage of a leverage of 125 times the money you have in your account. In general, each currency pair has a different leverage scale.
If you are right in your speculation and the exchange rate of the British Pound indeed rises, you retain the potential to earn profits on the equivalent of a $62,400 trade while committing only $500. This is great!
When using leverage is to understand that it can be a double-edged sword as well. For example, what happens if the exchange rate falls? A leveraged trade increases your earning potential but it also correspondingly increases the risk you undertake. This makes it important to decide whether it is worthwhile to leverage your transactions and by how much.
In currency trading, a trader enters a long position when he or she thinks that the exchange rate of a currency will rise. For example, consider the EUR/USD currency pair. If you think that the exchange rate of the Euro will rise against the US Dollar, you place a long trade on the currency pair. Note that when you go long on a currency, you simultaneously go short on the other.
For example, if EUR/USD is trading at 1.064. You think that the Euro will strengthen against the US Dollar and decide to take a Long position on a 10, 000 Euro trade with a leverage of 100:1.
The deposit needed will equal $106.4 (10,000 x 1.064/100).
Let’s assume you were right in your speculation and the exchange rate of the Euro rises against the US Dollar to close at 1.075. You can then sell the 10, 000 Euros at the new, higher price, making a profit.
The profit will equal (1.075-1.064) x 10,000, which is $110
Alternatively, if the Euro weakens against the Dollar and closes at 1.059, your loss will be (1.059-1.064) x 10 000, which is -$50.
Conversely, traders go short in the Online Trading market if they believe that the exchange rate of a currency will fall. Using the same example as above, let’s say you conduct some research into the EUR/USD market and you conclude that the exchange rate of the US Dollar will rise against the Euro. So you decide to enter a Short position with a leverage of 200:1 and sell 10,000 Euros at 1.070. While selling you Euro, you simultaneously buy US Dollars.
The deposit is calculated as 10,000 x 1.070/200, which is $53.5.
After a short time, the market moves in accordance with what you anticipated and the exchange rate drops to 1.062. You close the position and buy back €10,000 at a price of 1.062. You generate a profit because it now takes fewer US DOllars to buy back the same number of Euros.
The profit generated is calculated as (1.070-1.062) x 10,000, which is $80.