What is Forex?

Forex markets use the same terms to express market positioning as most other financial markets. But because currency trading involves simultaneous buying and selling, being clear on the terms helps — especially if you are totally new to financial market trading.

Going Long

A long position, or simply a long, refers to a market position in which you've bought a security. In FX, it refers to having bought a currency pair. When you are long, you are looking for prices to move higher, so you can sell at a higher price than where you bought. When you want to close a long position, you have to sell what you bought. If you are buying at multiple price levels, you are adding to longs and getting longer.

Going Short

A short position, or simply a short, refers to a market position in which you've sold a security that you never owned. In the stock market, selling a stock short requires borrowing the stock (and paying a fee to the lending brokerage) so you can sell it.

In forex markets, it means you are sold a currency pair, meaning you have sold the base currency and bought the counter currency. So you are still making an exchange, just in the opposite order and according to currency-pair quoting terms. When you have sold a currency pair, it's called going short or getting short and it means you are looking for the pair's price to move lower so you can buy it back at a profit. If you sell at various price levels, you are adding to shorts and getting shorter.

In currency trading, going short is as common as going long. "Selling high and buying low" is a standard currency trading strategy. Currency pair rates reflect relative values between two currencies and not an absolute price of a single stock or commodity.

Because currencies can fall or rise relative to each other, both in medium and long-term trends and minute-to minute fluctuations, currency pair prices are as likely to be going down at any moment as they are up. To take advantage of such moves, forex traders routinely use short positions to exploit falling currency prices. Traders from other markets may feel uncomfortable with short selling, but it's just something you have to get your head around.

Squaring up

Having no position in the market is called being square or flat. If you have an open position and you want to close it, it's called squaring up. If you are short, you need to buy to square up. If you are long, you need to sell to go flat. The only time you have no market exposure or financial risk is when you are square.

Margin is a deposit giving the trader the right to buy or sell the value of the underlying contract of a currency or derivative instrument. This margin requirement allows the investor to trade a larger amount of money with a relatively small deposit. The small margin payments are one of the main reasons why spot FX has become so attractive for individual investors.

Here's an example to help you understand how required margin ratios work. Say you have an account with a leverage ratio of 30:1 (so $1 of margin in your account can control a $30 position size), but your broker requires a 100% margin ratio, meaning you need to maintain 100% of the required margin at all times. The ratio varies with account size, but a 100% margin requirement is typical for small accounts. That means to have a position size of $3,000, you'd need $100 in your account, because $3,000 divided by the leverage ratio of 30 is $100. If your account's margin balance falls below the required ratio, your broker probably has the right to close out your positions without any notice to you. If your broker liquidates your position, that usually means your losses are locked in and your margin balance just got smaller.

Requirements may differ depending on account size and whether you are trading standard lot sizes (100,000 currency units) or mini lot sizes (10,000 currency units). Some brokers' liquidation policies allow for all positions to be liquidated if you fall below margin requirements. Others close out the biggest losing positions or portions of losing positions until the required ratio is satisfied again.

Profit and loss (P&L) is how traders measure success and failure. A clear understanding of how P&L works is especially critical to online margin trading, where your P&L directly affects the amount of margin you have to work with. Changes in your margin balance determine how much you can trade and for how long you can trade if prices move against you.

Unrealized and realized profit and loss

Most online forex brokers provide real-time mark-to-market calculations showing your margin balance. Mark-to-market is the calculation that shows your unrealized P&L based on where you could close your open positions in the market at that instant. Depending on your broker's trading platform, if you are long, the calculation will typically be based on where you could sell at that moment. If you are short, the price used will be where you can buy at that moment. Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and your realized P&L.

Realized P&L is what you get when you close out a trade position, or a portion of a trade position. If you close out the full position and go flat, whatever you made or lost leaves the unrealized P&L calculation and goes into your margin balance. If you only close a portion of your open positions, only that part of the trade's P&L is realized and goes into the margin balance.

Your unrealized P&L continues to fluctuate based on the remaining open positions, as does your total margin balance. If you've got a winning position open, your unrealized P&L is positive and your margin balance increases. If the market is moving against your positions, your unrealized P&L is negative and your margin balance is reduced. Forex prices change constantly, so your mark-to-market unrealized P&L and total margin balance also change constantly.

Calculating profit and loss with pips

Profit-and-loss calculations are pretty straightforward in terms of math — they're all based on position size and the number of pips you make or lose. A pip is the smallest increment of price fluctuation in currency prices. Pips can also be referred to as points; we use the two terms interchangeably. Looking at a few currency pairs helps you get an idea what a pip is. Most currency pairs are quoted using five digits. The placement of the decimal point depends on whether it's a JPY currency pair, in which case there are two digits behind the decimal point. All others currency pairs have four digits behind the decimal point. In all cases, that last itty-bitty digit is the pip.

No matter which trading style you decide to pursue, you need an organized trading plan, or you won't get very far. The difference between making money and losing money in the forex market can be as simple as trading with a plan or trading without one. A trading plan is an organized approach to executing a trade strategy that you've developed based on your market analysis and outlook.

Here are the key components of any trading plan:

Determining position size:

How large a position will you take for each trade strategy? Position size is half the equation for determining how much money is at stake in each trade.

Deciding where to enter the position:

Exactly where will you try to open the desired position? What happens if your entry level is not reached?

Setting stop-loss and take-profit levels: Exactly where will you exit the position, both if it's a winning position (take profit) and if it's a losing position (stop loss)? Stop loss and take-profit levels are the second half of the equation that determines how much money is at stake in each trade.