Mechanics of a Forex Trade - Non-USD Quote Currency

Beginner Questions
1

I have some questions regarding the basic mechanics of trading that I cannot find satisfactorily answered anywhere.

If my account balance is in USD then trades where the USD is the quoted currency make sense to me. For example, if the EURUSD is at 1.3000 then I understand that if I open a buy order, I am buying Euros with my USD, at $1.3 USD per Euro. Then when the Euro hopefully strengthens compared to the USD, I buy back USD at a profit.

However, what if USD is the base currency? For example what if I want to open a buy order on the USDJPY pair? Here, a buy order should mean buying USD with JPY, but I only have USD in my account. This implies I would first need to convert my USD to JPY, so that I would have JPY to buy USD, and since this doesn’t make any sense, I am certain I am misunderstanding something here.

The most confusing example is a cross-currency pair. If I want to open a buy order on the GBPJPY and my account only holds USD, then do I have to first buy JPY with my USD and then use that JPY to open the buy order and buy GBP? This would essentially be two forex orders simultaneously, would it not?

The most confusing part is that NO explanations or tutorials or videos I have found anywhere address how this all works, which suggests to me that I am somehow the only one who finds this all confusing. Obviously I understand the basic idea of buying a foreing currency in the hope that it will strengthen, at which point you can convert back to the original currency at a profit. However, the mechcanics of forex trading seem to go beyond that, though all explanations I can find do not go beyond the basic idea. People simply present that first basic idea, and then launch into discussions of buying and selling currency pairs without bridging the gap between those two concepts. I would really appreciate some explanations of the mechanics.

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2

When you take a position you are not actually literally buying or selling anything. All you are doing is taking a view on the future direction of the change in the exchange rate.

If you make a profit when you close the trade then you have gained a certain number of pips. If your acc is denominated in USD then the profit is credited with the USD value of those pips. If your account is denominated in, for example, Euros then the equivalent Euro amount is credited at the rate at which the trade was closed.

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Hey, thanks very much for the response. I have heard that before, that I am not actually buying or selling (ie. I am not actually buying, say, Euros with my USD). Again, though, what are the details here? Someone somewhere must be buying or selling something. If I am not actually buying or selling, where is the profit actually coming from? What happens on the broker’s end that makes this all work?

I tried to describe forex trading to someone and they asked all the questions I asked in my first post and I realized I had no idea how it actually works. I don’t want to offer up real money to a system that I can’t actually explain.

4

No, there is no need for anyone to be buying anything. For example, if I bet with you that the price of petrol tomorrow will have risen and you disagree and think it will do down, then we can decide to check it tomorrow and if it has risen then you pay me the difference and if it has gone down then I pay you the difference - no one has to actually buy any petrol at all!

Normally with retail traders your broker takes to other side of your position and if you “win” then he “loses” and pays you. If the position is very large (and many of them) then your broker can offset his risk by taking an opposite position himself in the market. If the trade is via ECN then the broker simply passes the trade straight through to the liquidity providers, who then hold the other side of your position.

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5

IMHO
A. If you buy 1 lot eurusd you would need $119,500 without leverage for margin.
With high leverage like 1:1000 you would need $119.50 for margin.
In the trade itself you have bought 100,000 EUR for $119,500.
So if the price move to lets say $120,000 USD you made $500 profit.
If your account currency is USD you will get $500 balance increase. And loss is vice versa.

B. If you buy 1 lot usdjpy you have bought 100,000 USD for 11,000,000 yen (at price 110.000 USDJPY.)
So if the price move to lets say 111.000 USDJPY you made 100000 yen profit ((111-110)*100000). Which is about $900 profit.
If your account currency is USD you will get $900 balance increase.
If it were YEN your increase will be 100000 yen.

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6

Hmmm I see this is starting to help. I think the betting analogy is probably good but we’re not quite betting. Let’s keep going with the petrol example. In practice, the system isn’t purely based on gambling over prices, it’s also backed by the fact that if you buy into petrol and it goes up, what you own is now worth more. All the betting and gambling can eventually be resolved into actual dollars by seling actual petrol.How does this factor into your analogy?

I think the answer is important because if I buy into Euros with USD and the Euro strengthens, the entire system is based on the fact that if I really owned Euros and walked into a US airport with them, I could exchange them for more USD than I paid for them. That’s where the profit “comes from”, so if nobody actually owns any of thoes Euros or USD, what do they own and who owns it?

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7

Naturally, one could buy and sell actual physical currency but then you would need the entire sum of money to do so. But retail forex trading is based on margin and leverage and not the full amount. Therefore you do not actually have the 100,000 units to open a 1 lot trade. If you did then there would also need to be a settlement process: you would need a USD bank account and a Euro bank account, giving instructions with your trade where the funds are to be transferred to and from and what settlement date and so on. This is not the case with our market.

If you like, it is similar to the futures and options markets and CFD’s. None of these involve actual deals with the underlying physicals, albeit they are sometimes exchangeable for the physical on expiry. These are often used to hedge actual positions in cash/commodities or future requirements. For example, oil producers will sell crude oil futures to lock in values of future production sales. They are not selling actual oil, they are selling derivatives based on the price of oil.

You are right that we are not actually gambling as such, but we are speculating purely with a profit motive. Our views are based on an assessment of the relative strengths/weaknesses of the two currencies in the pair we are trading and the likely resultant change in their relative values. This assessment is usually based on an analysis of relevant fundamental factors and/or chart-based technical evaluation of price movements.

But whether we call it gambling or speculating or even assisting in providing needed liquidity to the market ( :wink: ) the generation and settlement of the profit/loss is purely the difference in price between opening and closing the trade (and the nominal position size) and the two parties involved. There is no physical transfer of any capital involved - only the profit physically changes hands between the “winner” and the “loser” - i.e. real funds either to or from your actual numbered account with your broker.

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I’m sorry, I’m not trying to be obtuse, but there is still some crucial part missing for me. Where is the jump from actually exchanging physical currency to buying and selling currency pairs? The foundation of this entire operation must be actual exchange of currencies, otherwise this is all pretend. What if tomorrow at exactly midnight, some higher magical power yelled “Stop!” and everyone had to finally resolve all of their assets into real money. What happens, who owns what?

Can we go back to the USDJPY example rom my original question? I have USD in my account. I want to buy 1 lot of the USDJPY pair. What am I buying? What does the broker do? Am I borrowing JPY to buy USD? How much JPY am I getting for the USD in my accouint? Is the current exchange rate used to figure that out? Is the new exhcnage rate used when I convert back? Imagine the USD strengthens as I expected. Ignoring the fact that I already had USD, where is the USD I purchased with the JPY, and where is the JPY I get when I sell the order, and then how does that JPY turn back into USD in my account? And I understand there is no real exchange occurring, but I am still at a complete loss to explain what is happening. I am not familiar with future and options, I am new to trading entirely. This is all based on exchanging currency and it doesn’t seem like anyone exchanges any currency anywhere.

EDIT Manxx, if I sound defensive or difficult it’s only because I need to understand this, it’s not a comment on your responses. I am actually extremely grateful to be getting your feedback.

9

Its a bet Daniel. Nobody in private retail trading is buying or selling anything.

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10

That is perfectly ok. :slight_smile: It is much more rewarding to respond to someone genuinely seeking to understand what they are actually doing with their trading! That is precisely the right attitude to start this business with! You are doing precisely the right thing here! :slight_smile:

That about sums it up! With your USDJPY example you do not need any actual yen because you are not actually buying anything. The only actual exchange is done by the broker when converting your profit or loss into the currency of your equity account.

It is worth remembering though that there is a real forex market out there where real money does change hands at a current rate. This is important because this is why the rates used in retail forex based on margin has to mirror the real underlying market - otherwise one can arbitrage the two markets by, say, buying USDJPY in the cash market and simultaneously selling to your broker and making a risk-free profit (naturally, the spreads involved and time windows narrow the possibilities to do this unless you can deal in huge amounts as a high-worth customer with your bank. But within the finance industry this is possible if prices deviate sufficiently).

In other words, our market is exactly what you describe: a pretence, a fictitious, non-existent, pool of multicurrency funds…

Nothing except that all the open positions would settle their outstanding P/L obligations. This is exactly what happens if you are reckless enough to carry too many open positions and the losses on them, together with the margin requirement, exceeds your account balance - all your positions are automatically closed and your account is empty - but there are no assets anywhere to be resolved or transferred or ownership to be determined - it is just profit and loss. (In practice, your broker would have issued a margin call before your account was actually exhausted in order to give you time to add more funds if you wish or close out partial positions, etc).

Another (kind of) example: I buy a ticket to a concert for GBP 50 and then sell it to someone else for GBP 80. Then that person doesn’t go to the concert for some reason. I have made a real GBP 30 profit, the other guy has lost a real GBP 80 - there was a real, genuine concert, but neither of us actually went there!

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11

While we’re on that topic, I am also not 100% clear on that. If I buy GBPJPY with USD in my account, at what stage is there a conversion to or from JPY and USD?

But okay, thanks, I am learning a ton. I wish I could say the picture is getting clearer, but I am at least coming away with some important information I didn’t have before. I guess I can simply take it as a fact that there is no currency being actually exchanged, but I am still at a loss as to how this makes any sense and how there is an entire trading system built on nothing. That simply can’t be the case.

At the bottom of the abstraction ladder there are real human beings exchanging one currency for another, currencies that just so happen to oscillate in value relative to each other. At the top of the abstraction ladder, there are traders watching graphs on MetaTrader who know about that bottom layer but aren’t concerned with it and who aren’t even exchanging real currencies at all. It is one thing to know this state of things, as simply a known fact, but it frustrates me not to understand the intervening rungs of that ladder, and I have absolutely no idea where to go for that information.

The concert example makes sense, but, just like petrol, there really is a concert and there really is petrol and at some point somebody could really take that ticket and go to the concert, even though nobody does, and somebody could really put that petrol into their car and drive around, even though they don’t. Where is the real concert in the Forex market? Because it sounds like we all just agree to pretend there are concerts and then start exchanging tickets, and that’s insane.

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Good question! :slight_smile: And that is why the governments and central bänks around the globe watch and (try to) regulate these markets.

Their prime benefit to the world in general is that they help to provide liquidity to the real money markets.

Whenever a company buys or sells things in foreign currencies, or borrows money in another currency, or an investment fund or pension fund wants to invest in something denominated in another currency, or anyone buys or sells securities,shares, bonds etc denominated in another currency, or you buy something on E-Bay or change money for your holiday abroad, real currency transactions take place.

These transactions are mostly carried out via bänks who function as market-makers. They constantly quote a bid and offer with a spread in between and are prepared to buy or sell according to the customer’s wish and the actual funds are transferred to and from the customer’s bank accounts in the two currencies. So the bank has assumed the other side of the transaction. The bank now needs to decide whether to hold the position or enter an opposite position with another market-maker - and so the money goes round.

But the efficiency of this market requires constant and deep levels of liquidity so that prices move smoothly up and down and not jump all over the place and with periods with no price available anywhere, For this reason speculative trading is allowed.

Therefore these pseudo markets or financial derivitives fulfill this role of providing liquidity by allowing one set of customers to secure a desired price level by contracting with another opposite set of customers willing to take the risk of the opposite position. There is a financial market, and there is a petrol station and there is a concert, but we do not need to be the ones actually using them on order to trade them provided the prices of the real market are mirrored in the derivitives by normal free market activities.

Read a little about the futures markets for commodities like oil, metals, coffee, grains, etc. These are huge markets used by producers, consumers and speculators. The futures contract is an obligation for a specified unit of a product at a specified quality at a specified price for a specified date in the future. These contracts are freely bought and sold without any physical delivery until the actual expiry date. Then, if any contracts are still open, they can be swapped into a physical delivery. But in practice, at least with financial futures, they are closed out before the expiry date with just a P/L settlement. Our market is similar but without the set expiry date.

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13

This has been the best explanation I’ve heard to date. I can’t thank you enough for taking the time to get into this with me, this has been a really interesting discussion for me.

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14

You are welcome. I am sure (and hope) that if I have said anything wrong then someone will correct me!

One last point regarding the benefit of speculative activity and pseudo currency markets:

When companies agree large deals involving significant payments or receipts in foreign currencies, those payments may not actually be made until many months later or in stages over a period of time. For example, if you are building a new factory abroad you will pay the contractors in a series of agreed stages. But your financial calculations are based on certain exchange rate price levels. You do not need to actually move any funds right now but you do want to fix the price now.

So you can go to your spot broker, futures broker, or bank and contract a price now to hold until you need the funds. You buy the actual funds at the current price and simultaneously close your derivitive position. The loss on one with equate with the gain on the other and thereby ensuring your cost is what it was when you needed to set it.

This is perfectly legitimate and desirable and certainly enables international commerce to take place on a more secure and reliable basis. Without the ability to fix currency price many business deals would either not take place or could go bust even though the actual business idea was sound, simply because the original financial basis on which it was based is no longer valid due to exchange rates moving the wrong way!

But that is surely enough for one day! :smiley:

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Hahah definitely enough for one day. Thanks again!!