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How do we manage a Forex trade so that the risk is fixed and we know the risk-reward of the trade in advance?

Forex trading is only a little different to trading any other type of security. In this story I show you the main differences so you can apply a systems method to trading currencies. To illustrate, in the next story I will apply the method described below to AUD.JPY, the cross between the Australian Dollar and the Japanese Yen.

Forex trading is conducted in the relatively unregulated interbank market where individual banks conduct foreign currency business over the phone or via networked quote entry systems. These quotes are accumulated by several vendors and distributed back to the banks as well as via trading systems to worldwide forex traders. A very common platform for individual traders is Metatrader which is widely available for free once you've opened a trading or a demo account.

In an earlier story on how to set up a trade in the futures market, I showed the different sizes for various futures contracts. To recap, forex contracts are typically 100,000 units of the base currency and the price for each unit of the base is displayed in units of the quote currency. Currencies are displayed here in the format:

   BaseFX is the currency which is being bought or sold.
   QuoteFX is the currency the contract is priced or quoted in.
   The Quote currency is also called the Counter currency.

For example, we write AUD.JPY for the purchase of contracts of AUD valued in JPY or Japanese Yen. Other common ways you will see BaseFX.QuoteFX pairs displayed are AUDJPY and AUD/JPY.

Often the joining dot or period is replaced with a division symbol or omitted altogether. In the text below I use a period to help make the relation clearer.

BASE.QUOTE Contract Size Priced In
AUD.JPY 100K Australian Dollars Japanese Yen
AUD.USD 100K Australian Dollars US Dollars
USD.CAD 100K US Dollars Canadian Dollars
USD.JPY 100K US Dollars Japanese Yen
EUR.USD 100K Euros US Dollars

Although the normal contract size is 100,000 units (100K), many brokers allow fractional quantities served up in mini sized contracts of 10K or even 1K units.

How do Base and Quote Currencies Work

What makes Forex a little confusing is that there are at least two currencies involved, and often a third - your account currency. Let's walk through them one at a time.

The base currency sounds like a price but it is actually a commodity you can buy or sell, like an apple. And just like an apple, this commodity has a price quoted, but in another currency called, naturally enough, the quote currency. Just as an apple costs, say $0.50c, a unit of AUD costs a given amount determined by the current market. For the AUD.JPY contract, at the time of writing, one AUD costs 84.50 Japanese Yen. It is priced in Yen because Yen is the quote currency that follows after the period.

If you have a trading account, it will be set up in at least one currency called the account currency. When you make a trade, your profits and losses usually accumulate in the quote currency and are converted via a separate transaction to your account currency.

That's different to the case where you set out to buy or sell a foreign currency for its own sake, either to purchase from or sell an item to a foreign entity. In this latter case you would take delivery of the foreign currency, the AUD. Your trading account may or may not allow delivery. In the same way, trading futures usually resolves as a cash transfer, not the delivery of wheat or pork bellies.

Since your trading account is probably a margin account, to open a long position in AUD.JPY, you will be borrowing the Yen to sell in order to buy the AUD. You will pay interest on the Yen and receive interest on the AUD until you close the long position.

The AUD.USD contract, on the other hand, quotes the price of one unit of AUD in US Dollars. The current price of one AUD is US$0.7602. Notice the extra decimal places after the usual cents ($0.7602)? Each currency has a standard number of decimal places for every market price quote. These are called pips, from Point In Percentage. For the AUD four decimal places are displayed in every price quote. If the AUD increases from US$0.7600 to 0.7602 we say that it increased by two pips. That is, the AUD has become slightly more expensive to a US buyer, just as an increase in the price of an apple makes it more costly.

Quote currencies that do not trade in the street with decimals, such as the Yen and formerly the Italian Lira, will probably only have two decimals places reserved to display pips. For example, the AUD.JPY is quoted as 84.50.

Depending on your quote platform, you will probably see an extra 5th (and 3rd for Yen) decimal place quoted along with the above four because many vendors provide half pips and smaller. These are sometimes called pipettes, or more commonly just "half a pip", and written as 0.76025.

We will need to go through these numbers in depth so that we can place a trade, but first let's look at the obvious question here:

What Determines Which Currency is the Base and Which is the Quote?

Why is the AUD contract expressed as AUD.USD but the Japanese and Canadian contracts written in terms of the non USA currency, USD.CAD and USD.JPY? Why is the Euro written as EUR.USD and not USD.EUR? Well the short answer is that you can write them any way you like providing there is a market and your broker supports those reverse contracts. However, most if not all quote vendors express the contracts in the same ratios I use here.

BASE.QUOTE Quoted in
USD.CAD Canadian $
EUR.CHF Swiss Francs
USD.CHF Swiss Francs
USD.MXN Mexican pesos
USD.CNH Chinese Renminbi or Yuan (offshore)

The long answer is murkier and almost lost in the history of forex markets. Given my four decades or more working with Forex, I describe my own beliefs on the origin of the currency ratios here, but I am by no means 100% certain. TL;DR I suggest it's because of the ratio of one currency to the other. If a currency back in the 1970s traded consistently under one US$, especially the Italian Lira or the Yen, it was designated the quote currency and vice versa. Today we just keep using the established contract tickers for historical reasons.

The Significance of the Quote Currency

The quote currency is the currency of the trade. It is the amount paid or received for buying or selling one unit of the base currency. If you are based in the USA and the quote currency is also the USD, such as AUD.USD, then you can value the contract in the same way as any US futures or equity position. You will receive USD if a long postion rises in value or pay out USD from your account if the position falls.

You are simply buying or selling units of AUD like any other commodity. In the special case of USD as the quote currency for US accounts, currencies do not really enter into the calculations!

Your local currency is your account currency, the currency in which you add up your profits and losses. It might or might not be the quote currency.

None of this matters if you are simply looking for signals on the chart because then you are only concerned with the open, stop and target prices and the RR multiplier between risk (OP - SL) and reward (TP - OP). However as soon as you want to open a position, you will need to know the number of contracts. That's when the calculations below come in handy.

If the quote currency is not your account currency then the trade will lead to a certain amount of foreign currency flowing into or leaving your account each day as the position is marked to market. Your broker may automatically convert those winnings or losses into your account currency for a fee, but the mechanism remains the same.

When you calculate the trade setup, you must take into account the conversion of the amount at risk to your account currency so that you can compute the number of contracts to open. You will remember from the first series on The Basic Setup that the value of the risk per contract is divided into funds at risk in order to calculate the position size:

Number of contracts = ($Funds at risk) / ($risk per contract)

The funds at risk are normally 1% to 2% of your risk capital.

Since the funds at risk are in your account currency, you must convert the amount at risk in the trade into that same currency. This step was not required when you were buying futures because there I only discussed futures priced in your local currency. Here we have to convert the risk value back to your local currency. None of this arithmetic is hard but because of the multiple currencies it is no doubt tricky to get your head around. To help, I will do a couple of examples below.

Keep in mind what I wrote above about how the currencies are quoted - we need to know which currency is used to value the contract whenever we discuss a forex pair. It is always the quote currency on the right hand side.

I will take the example of AUD.JPY and consider our account currency to be the USD. This works just as well for anyone whose account currency is not JPY. Just replace the conversion from Yen to US$ with your Yen/local rate. I will show you how to do that below. For JPY account holders, this position is just like any other domestic Japanese security priced in Yen except it has a contract size of 100K. Yen account holders should refer below to the AUD.USD example 2.

AUD account holders could take a short cut and use the inverse of the market price of AUD.JPY at OP and SL to calculate the risk in AUD.

Let's look at those examples now in our next story Examples of how to Manage Risk in a Forex Trade.

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