Forex Trading Basics

In order to understand how forex trading works, this short article explains the most important terms that we’ll be using on a daily basis when trading forex. Firstly, let’s look into what Forex stands for: Forex or Foreign Exchange is the marketplace where all the world’s currencies trade and is the place where you can speculate whether one currency will get stronger or weaker relative to another currency.

These are the key Forex terminologies crucial to the currency market that every newbie in the forex world should know before she/he starts trading:

What is a Currency Pair?

Now that you know the basics of what Forex is, the first thing that you need to understand is what you’re looking at when you see a currency pair, when you look at a currency table or when deciding to trade a pair you’ll see the symbols of the currency available to trade.

Based on Investopedia definition:” A currency pair is the quotation and pricing structure of the currencies traded in the forex market; the value of a currency is a rate and is determined by its comparison to another currency”

The first currency mentioned in a pair is called the “Base Currency” and the second currency is called the “Counter Currency” or the “Quote Currency.”

base-quote-currency

Currency Pair Quotation

Currency Pairs can be separated into three main groups: the Majors, the Crosses, and the Exotics. The majors are those currencies that represent the major economies and are traded against the US Dollar. The majors are the most commonly traded pairs. The crosses are pairs, usually of major currencies, that don’t include the US Dollar. Finally, we have the exotics which include the currencies of emerging economies.

Types of Currency Pairs

Types of Currency Pairs

What is a pip?

Forex Pip

Forex Pip

Currency exchange rates fluctuate in fractions of a dollar called Pip (Price Interest Point). A pip is the smallest price movement that any currency pair can make and is the last decimal of a quote. A pip is also the unit used to express the price change of an exchange rate.  Exchange rates are mainly quoted to the fourth decimal place, the exception being the Japanese Yen pairs.

The standard quotation system uses four decimals (two decimals for Yen pairs). However, some brokers use a 5 decimal quotation system (and 3 decimal quotation system for the Yen pairs)

1 Pip = 1% of 1% or 0.0001

What is the Pip Value?

 

The Pip Value represents how much the smallest price movement of an exchange rate is worth in dollar amount and how much money we’re making or losing. Each currency has its own relative value which means that a Pip has a minimal value on its own. The Pip Value is also determined by the contract size of your position and the higher the number of lots traded the higher the Pip Value will be.

In major pairs quoted against the US Dollar, we calculate the value of a pip as follows:

Pip Value = (Pip/Exchange Rate) * Lot size

Example 1: If we sell 1 standard lot (€100,000) of EUR/USD at the current market price of 1.1322, then each pip move in our favor will be worth €8.83 ($10).

Pip Value = (0.0001/1.1322) * 100,000 = €8.83 ($10)

In the case of Crosses (which don’t have the US Dollar in their quotation) we calculate the value of a pip as follows:

                    Pip Value = [(One Pip / Exchange Rate) * Lot size]*Base Currency Exchange rate

Example 2: If we sell 1 standard lot (€100,000) of EUR/JPY at the current market price of 113.52, then each pip move in our favor will be worth $9.97. The conversion rate of the Base currency EUR/USD is 1.1322.

Pip Value = [0.01/113.52) * 100,000] *1.1322 = $9.97

What is a Lot?

A lot is an industry term used to describe the size of a trade. Forex traders can determine the size of the order in lots and by default, all orders are set at one lot, but you can customize this value as per your preferences. In Forex Trading there are several different Lot sizes as follows:

  • Nano lot = 100 units of Base Currency;
  • Micro lot = 1000 units of Base Currency;
  • Mini lot = 10,000 units of Base Currency;
  • Standard lot = 100,000 units of Base Currency;

Buy and Sell (Bid and Ask Price)

what-is-a-lot

When dealing with currency pairs in forex trade we already learned that the first currency is often referred to as the Base currency and the second currency is often referred to as the Quote currency. After you have selected a currency pair you will determine if you want to sell or buy the Base currency using the Quote currency. You buy a pair if you believe that the Base currency will appreciate (or go up) relative to the Quote currency and you sell a pair if you think that the Base Currency will depreciate (or decline) relative to the Quote currency.

Currencies typically have two prices:

  1. The sell price also referred to as the Bid price which is the amount at which the market will buy one unit of the base currency using the quote currency.
  2. The buy price also referred to as the Ask price which is the amount at which the market will sell one unit of the base currency using the Quote currency.

What is the Spread?

The Bid price is always smaller than the Ask price and the difference between them is popularly known as the Spread. The size of the Bid-Ask spread of a currency pair is one measure of the liquidity of the market. To better understand the Spread let’s look at an example of a trade: for the EUR/USD pair the Bid price is 1.1322 and the Ask price is 1.1324, it means that the difference between the two prices 1.1324 – 1.1322= 2 pips is the Spread.

Spread = Ask – Bid

Types of Orders

An order is an instruction from trader to Broker and it shows the way how a trader wants to enter or exit the market. Going forward you’re going to be introduced to the most common types of Forex orders:

  • A Market Order buys or sells the currency pair immediately at the current exchange rate determined by the market and therefore cannot be changed. This type of order guarantees that the order will be executed at the best available price. In a fast-moving market, the price paid or received might be quite different from the last price quoted before the order was entered.
  • A Limit order is an order placed to buy or sell at a certain predetermined price. The limit order is typically based on two variables: price and duration. The limit price will always be below the current market price in case of a Buy Limit Order and above the current market price in case of a Sell Limit Order.
  • A Stop Loss order tells the system to close a position when it reaches a certain price. A Stop Loss order is designed to limit traders potential loss. This type of order remains in effect until your position is liquidated or until you cancel the Stop Loss Order.
  • A Take Profit order is an order used to cash in profits in case the exchange rates move in the direction of your trade.