Leverage and forex trading
Pairs trading on the forex market
A forex trader buys one currency while selling the other. For example, a trader buying the EUR/USD pair is long the euro (EUR) and short the U.S. dollar (USD). And the rate is simply the ratio—the numerator over the denominator. Other actively traded pairs include USD/JPY, GBP/USD, USD/CAD, AUD/USD, and NZD/USD. Major currency pairs consist of any two of the following currencies:
- USD: U.S. dollar
- JPY: Japanese yen
- EUR: Euro
- AUD: Australian dollar
- NZD: New Zealand dollar
- CAD: Canadian dollar
- GBP: British pound
- CHF: Swiss franc
All other currency pairs are considered "exotic."
The minimum price movement in the forex market is called a pip. For example, if the quote for EUR/USD is 1.4168 bid to 1.4170 ask, and one pip is 0.0001, the difference in price between the bid and ask is two pips. Like stocks, forex traders buy at the ask and sell at the bid.
For many currencies, the pip is equal to 1/100 of a cent, or 0.0001, except for JPY pairs where the pip is equal to 0.01. For a $100,000 trade, a pip usually equals $10. A trader who captures 10 pips on such a trade makes $100. Conversely, by losing 10 pips on a trade, a trader loses $100. The ultimate value of a pip is determined by the size of the trade and the currency pair being traded. Retail forex traders can trade in increments as small 10,000 units.
For example, if a trader bought 20,000 units of AUD/USD, each pip would be worth $2 (20,000 x 0.0001 = $2). If a trader bought 20,000 units at 0.7126 and sold them at 0.7118, an 8-pip loss, they’d have lost $16.
Leverage and forex trading
In forex trading, margin requirements vary as a percentage of the notional value. Margin requirements at Schwab are typically between 3% and 5% of the notional value, although certain pairs can be as low as 2% or higher than 5%. Leverage can magnify losses as well as profits. A small amount of market movement can have a large effect—positive or negative—on an account's profit and loss1 (P&L).
Understanding "roll" in currency positions
Forex traders should also understand how interest rates could impact their P&L when holding positions through the close of trading from one trading day to the next. Forex trading creates a situation where a trader is essentially holding one long currency and shorting the other currency in the pair. A trader can earn interest on the long currency and pay interest on the short currency when keeping a position from one trading day to the next. The differential between the two interest rates amounts to what's called the "net financing rate." Depending on the situation, the net financing amount could increase or decrease the value of a position.
