Mechanics of a Forex Trade

For those who are thinking about entering the forex market for the first time, there is some very basic information that is often overlooked. For example, what exactly is happening when you enter a trade? Well it’s simple really, but important to understand. Say, for example, that you have a shiny new $10,000 account. You find a great entry on EUR/USD that you want to take. You enter a 1 mini lot long position with a 100 pip stop loss and a 200 pip take profit target at a price of 1.2500. What just happened? In the meantime, what you have done so far is you borrowed USD12,500 and traded it in for EUR10,000. Now EUR/USD moves in your favor and hits your take profit order at 1.2700. What that order does is sell the EUR10,000 that you are holding and buys USD at the current rate, meaning you get USD12,700 because the rate is now 1.2700. Now you pay your original loan back to your broker, which was USD12,500 and congratulations! You have just pocketed $200 on your first trade. Please note that in the above example we did not consider any spread or other transactions costs – it is assumed that the entry price of 1.2500 was the ask price, and the exit price of 1.2700 was the bid price.

Forex Price Dynamics

In order to gain an understanding of what actually moves the prices, or exchange rates in the interbank market, we must first understand that for any transaction to take place, there must be a buyer and there must be a seller – there must be a counter party for every trade. Open interest in the forex can be loosely defined as the combination of all resting (limit) orders. Many market participants set such orders either above (sell limit) or below the current price (buy limit). These orders are to be filled only when price reaches the set level. For example, say we are trading EUR/USD and the current bid price is at 1.2500. We set a sell limit order at 1.2501. When will our order get triggered? Once all the sell orders at 1.2500 have found buyers, the bid price will move up to the next available level, which is 1.2501. Once buyers enter the market at that price (they would actually be paying the ask price, and the broker would collect the difference), they become the counter party to our trade and our order is filled. One way to look at it is that there are essentially 2 types of orders: limit orders and market orders. There are other types, but they can always be classified as sub-types of these two. Limit orders are set to execute if and only if a set price level is reached, while market orders are set to execute at the current market price. Alternately, limit orders can be described as providing open interest, while market orders can be described as consuming open interest. This is a very important distinction because it is the backbone of price dynamics.

It should be noted that the only relationship between bid and ask prices is that the ask price, by its definition, should never be lower than the bid price. In every other aspect, the two are unrelated, so the spread between the two varies according to where the open interest lies. During times of low liquidity there may be no one interested in buying above 1.2450 and no one interested in selling below 1.2550, making the spread 100+ pips. This is not necessarily the product of shady dealer practices (though at the retail level it may be), but is more likely caused my normal market mechanics – all open interest was either consumed by market orders, or withdrawn (limit orders can be cancelled before they are executed). This type of situation normally happens when important, unexpected information enters the market, such as an NFP reading that is way off the mark. In that case, open interest in one direction will be consumed by a barrage of market orders, and open interest in the other direction will be withdrawn by market participants cancelling their orders. This is equivalent to saying that liquidity is “drying up”, and that the bid price will gap down until it finds a buy limit order, and likewise, the ask price will jump up until it reaches a sell limit order. Note that no one has come in and “set” the spread. The spread is not a parameter that can be set, but is rather the result of market mechanics at their most basic level. It also should not be a surprise that, although today’s technology is lightning fast, there are delays between market order entry and execution, during which time the open interest at the desired level can be consumed, particularly in fast moving markets. In such circumstances, there is no longer a counterparty to take the market order at the desired level, and it can either be filled at a worse price (slippage), or it can be re-quoted. Again, this is not necessarily indicative of any malpractice by your broker, but is more often than not a natural result of market mechanics and the delays inherent in communication media. It should be noted however, that once prices have moved through several tiers and they reach the retail level, they may or may not have been “massaged” by someone along the way (a practice known as price shading). This is the reason many quote for their preference in trading through an ECN rather than a traditional retail broker. In reality, there are advantages and disadvantages to both. You can explore exactly how and why this is true in our follow-up article How Forex Brokers Work.