The mechanism of the forex market is quite different when compared with other markets like stocks and commodities. In the stock market, we essentially consider a company’s stock to trade. But in the foreign exchange market, we cannot trade a single currency. Instead, we must trade them in pairs.
In the previous lessons, we understood the meaning of base and quote currencies and also the right way to read the symbols. In this lesson, let’s explain how exactly this buying and selling happens in the Forex market.
The working principle
Before getting into the topic, let us understand a few common terms to grip the concept much better.
Long – It is a basic term in trading, which refers to the ‘buying‘ of security.
Short Selling – This term refers to the ‘borrowing’ of security from the broker and selling it at the current market price. You can assume this to be the right opposite of long. Note that Shorting security and selling security are two different terms.
For example, let’s say you went long on a security, and now you wish to close it. To close it, you will have to ‘sell’ it. Here, you are ‘selling’ and not ‘shorting’ the security.
Now, with this on our back, let us get into the working of buying and selling currency pairs.
Going Long on a Currency Pair
When you go long on a currency pair, you actually buy the base currency, and short sell the quote currency. For example, if you go long 100,000 units on EUR/USD, you are buying 100,000 Euros and short selling 100,000 US Dollars.
Short Selling a Currency Pair
Short selling in the forex market is quite different from that of the stock market. In the forex market, when you short sell a currency pair, you will be selling the base currency and buying the quote currency. Hence, shorting in forex is the same as placing a regular sell order.
However, the main motive remains that the prices must decline from the point you executed the short position to generate a profit. For example, if you short 10,000 units of USD/CAD, you are actually selling 10,000 US Dollars and buying the same number of Canadian Dollars. Hence, here, you’re not borrowing a certain amount of currency to go short.
With the concept of the long and short sell, let us understand how to make a profit from it.
To profit from a long trade, you need the currency pair prices to increase.
To profit from a short trade, you need the currency pair prices to decline.
This also implies that, in a long trade, an increase in the base currency prices will put you in profit, and in a short trade, a decrease in the base currency prices will give you profits.
Consider the current market price of USD/CHF to be 0.9850. Let’s say you went long on this currency pair. The buy/sell mechanism here is simple – you bought the USD (the base currency) and simultaneously short sold the CHF (the quote currency). Hence, to make a profit from this, you need currency pair prices to increase, which in turn means that you need the value of the base currency (USD) to increase or the value of the CHF to decrease because you’ve bought the USD.
This is how the buying and selling of currency pairs work internally. However, since all of this is managed by the broker, all you need to know is if the prices should rise or fall according to the position you took.
In the next article, we will be discussing the sheer size and liquidity of the Forex market along with the perks involved. For now, check if you can get the below questions right.