Exchange rate

An exchange rate is the relative price of two currencies from two different countries.

You find “Japanese yen” and think to yourself, “WOW! My one dollar is worth 100 yen?! And I have ten dollars! I’m going to be rich!!!”

When you do this, you’ve essentially participated in the forex market! You’ve exchanged one currency for another.

Or in forex trading terms, assuming you’re an American visiting Japan, you’ve sold dollars and bought yen.

Before you fly back home, you stop by the currency exchange booth to exchange the yen that you miraculously have remaining (Tokyo is expensive!) and notice the exchange rates have changed.

It’s these changes in the exchange rates that allow you to make money in the foreign exchange market.

Major currencies

While there are potentially lots of currencies you can trade, as a new forex trader, you will probably start trading with the “major currencies“.

They’re called “major currencies” because they’re the most heavily traded currencies and represent some of the world’s largest economies.

Forex traders differ on what they consider as “major currencies”.

The uptight ones who probably got straight A’s and followed all the rules as children only consider USD, EUR, JPY, GBP, and CHF as major currencies.

Then they label AUD, NZD, and CAD as “commodity currencies“.

For us rebels, and to keep things simple, we just consider all eight currencies as the “majors”.

Currency symbols always have three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country’s currency, usually the first letter of the currency’s name.

Example: USD. “US – United States” and “D – Dollar”.

Liquidity

Liquidity describes the extent to which an asset can be bought and sold quickly, and at stable prices, and converted to cash.

Liquidity refers to how quickly and at what cost one can sell an asset, whether that is a financial asset such as a stock or a real asset such as a commercial building.

If one has an asset whose “true,” or fundamental, value is $100, and one can instantly convert that asset into $100 of cash or cash equivalent, then we think of the market for that asset as perfectly liquid.

Of course, such a perfectly liquid market is rarely observed in the world.

Liquidity is also used to measure how quickly a buyer of an asset can convert cash into that tangible asset.

So in a perfectly liquid market, someone who is looking to buy an asset whose fundamental value is $100 will be able to purchase that asset instantly for exactly $100 and receive it instantly.

It is a measure of how many buyers and sellers are present, and whether transactions can take place easily.

Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market.

Liquidity is considered “high” when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller.

If there are only a few market participants, trading infrequently then liquidity is considered to be “low”. This is known as an illiquid market.

The Dollar is King in the Forex Market

The U.S. dollar is the most traded currency, making up 84.9% of all transactions! The euro’s share is second at 39.1%, while that of the yen is third at 19.0%. As you can see, most of the major currencies are hogging the top spots on this list!

You’ve probably noticed how often we keep mentioning the U.S. dollar (USD).If the USD is one-half of every major currency pair, and the majors comprise 75% of all trades, then it’s a must to pay attention to the U.S. dollar. The USD is king!

In fact, according to the International Monetary Fund (IMF), the U.S. dollar comprises roughly 62% of the world’s official foreign exchange reserves! Foreign exchange reserves are assets held on reserve by a central bank in foreign currencies.

Because almost every investor, business, and central bank own it, they pay attention to the U.S. dollar.

The Different Ways To Trade Forex

Because forex is so awesome, traders came up with a number of different ways to invest or speculate in currencies.

Among the financial instruments, the most popular ones are retail forex, spot FX, currency futures, currency options, currency exchange-traded funds (or ETFs), forex CFDs, and forex spread betting.

It’s important to point out that we are covering the different ways that individual (“retail”) traders can trade FX. Other financial instruments like FX swaps and forwards are not covered since they cater to institutional traders.

Futures are contracts to buy or sell a certain asset at a specified price on a future date (That’s why they’re called futures!).

An “option” is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date.

A currency ETF offers exposure to a single currency or basket of currencies. ETF allow ordinary individuals to gain exposure to the forex market through a managed fund without the burdens of placing individual trades.

The spot FX market is an “off-exchange” market, also known as an over-the-counter (“OTC”) market. The forex market is a large, growing, and liquid financial market that operates 24 hours a day.

Spread betting is a derivative product, which means you don’t take ownership of the underlying asset but speculate on whichever direction you think its price will move up or down.

A forex CFD (Contract For Difference) is an agreement (“contract”) to exchange the difference in the price of a currency pair from when you open your position versus when you close it.

In our forex trading sessions, we’ll explain this in detail.

Base and Quote Currency

Currencies are always quoted in pairs, such as GBP/USD or USD/JPY. The reason they are quoted in pairs is that, in every foreign exchange transaction, you are simultaneously buying one currency and selling another.

How do you know which currency you are buying and which you are selling? Excellent question! This is where the concepts of base and quote currencies come in.

Whenever you have an open position in forex trading, you are exchanging one currency for another.  Currencies are quoted in relation to other currencies. Here is an example (picture on the left) of a foreign exchange rate for the British pound versus the U.S. dollar.

The first listed currency to the left of the slash (“/”) is known as the base currency (in this example, the British pound). The base currency is the reference element for the exchange rate of the currency pair. It always has a value of one.

The second listed currency on the right is called the counter or quote currency (in this example, the U.S. dollar).

When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy ONE unit of the base currency. In the example above, you have to pay  1.21228 U.S. dollars to buy 1 British pound.

When selling, the exchange rate tells you how many units of the quote currency you get for selling ONE unit of the base currency. In the example above, you will receive  1.21228 U.S. dollars when you sell 1 British pound.

The Bid, Ask and Spread

All forex quotes are quoted with two prices: the bid and ask. In general, the bid is lower than the ask price.

The bid is the price at which your broker is willing to buy the base currency in exchange for the quote currency. This means the bid is the best available price at which you (the trader) can sell to the market. If you want to sell something, the broker will buy it from you at the bid price.

The ask is the price at which your broker will sell the base currency in exchange for the quote currency. This means the ask price is the best available price at which you can buy from the market. Another word for ask is the offer price.

The difference between the bid and the ask price is known as the SPREAD; in this example 2 pips.

On the GBP/USD quote (picture on the left), the bid price is 1.3089 and the ask price is 1.3091. Look at how this broker makes it so easy for you to trade away your money.

• If you want to sell GBP, you click “Sell” and you will sell pounds at 1.3089.
• If you want to buy GBP, you click “Buy” and you will buy poundss at 1.3091.

Margin Trading

“But I don’t have enough money to buy 10,000 euros! Can I still trade?”

You can! By using leverage.

When you trade with leverage, you wouldn’t need to pay the 10,000 euros upfront. Instead, you’d put down a small “deposit”, known as margin. Leverage is the ratio of the transaction size (“position size”) to the actual cash (“trading capital”) used for margin.

For example, 50:1 leverage, also known as a 2% margin requirement, means $2,000 of margin is required to open a position size worth $100,000. Margin trading lets you open large position sizes using only a fraction of the capital you’d normally need.

This is how you’re able to open $1,250 or $50,000 positions with as little as $25 or $1,000. You can conduct relatively large transactions with a small amount of initial capital.

When you decide to close a position, the deposit (“margin”) that you originally made is returned to you and a calculation of your profits or losses is done. This profit or loss is then credited to your account.

A small margin deposit can lead to large losses as well as gains. It also means that a relatively small movement can lead to a proportionately much larger movement in the size of any loss or profit which can work against you as well as for you.

For example, you open a forex trading account with a small deposit of $1,000. Your broker offers 100:1 leverage so you open a $100,000 EUR/USD position. A move of just 100 pips will bring your account to $0! A 100-pip move is equivalent to €1! You blew your account with a price move of a single euro.

What is a Pip in Forex?

Here is where we’re going to do a little math. Just a little bit.

You’ve probably heard of the terms “pips,” “points“, “pipettes,” and “lots” thrown around, and now we’re going to explain what they are and show you how their values are calculated.

Pip – The unit of measurement to express the change in value between two currencies.

If EUR/USD moves from 1.1150 to 1.1151, that .0001 USD rise in value is 1 PIP. A pip is usually the last decimal place of a price quote.

Most pairs go out to 4 decimal places, but there are some exceptions like Japanese yen pairs (they go out to two decimal places). For example, for EUR/USD, it is 0.0001, and for USD/JPY, it is 0.01.

What is a Pipette?

There are forex brokers that quote currency pairs beyond the standard “4 and 2” decimal places to “5 and 3” decimal places. They are quoting FRACTIONAL PIPS, also called “points” or “pipettes.”

A “point” or “pipette” or “fractional pip” is equal to a “tenth of a pip“. For instance, if GBP/USD moves from 1.30542 to 1.30543, that .00001 USD move higher is ONE PIPETTE.

What is a Lot in Forex?

Forex is commonly traded in specific amounts called lots, or basically the number of currency units you will buy or sell.

A “lot” is a unit measuring a transaction amount.

When you place orders on your trading platform, orders are placed in sizes quoted in lots. It’s like an egg box. When you buy eggs, you usually buy a box. One box includes 12 eggs.

The standard size for a lot is 100,000 units of currency, and now, there are also mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units.

Some brokers show quantity in “lots”, while other brokers show the actual currency units. As you may already know, the change in a currency value relative to another is measured in “pips,” which is a very, very small percentage of a unit of currency’s value.

To take advantage of this minute change in value, you need to trade large amounts of a particular currency in order to see any significant profit or loss. Let’s assume we will be using a 100,000 unit (standard) lot size. We will now recalculate some examples to see how it affects the pip value.

1. USD/JPY at an exchange rate of 119.80: (.01 / 119.80) x 100,000 = $8.34 per pip
2. USD/CHF at an exchange rate of 1.4555: (.0001 / 1.4555) x 100,000 = $6.87 per pip

In cases where the U.S. dollar is not quoted first, the formula is slightly different.

1. EUR/USD at an exchange rate of 1.1930: (.0001 / 1.1930) X 100,000 = 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip
2. GBP/USD at an exchange rate of 1.8040: (.0001 / 1.8040) x 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.

Your broker may have a different convention for calculating pip values relative to lot size but whatever way they do it, they’ll be able to tell you what the pip value is for the currency you are trading at that particular time.

In other words, they do all the math calculations for you! As the market moves, so will the pip value depending on what currency you are currently trading.

How to calculate profit and loss

So now that you know how to calculate pip value and leverage, let’s look at how you calculate your profit or loss.

Let’s buy U.S. dollars and sell Swiss francs. The rate you are quoted is 1.4525 / 1.4530. Because you are buying U.S. dollars you will be working on the “ASK” price of 1.4530, the rate at which traders are prepared to sell.

So you buy 1 standard lot (100,000 units) at 1.4530. A few hours later, the price moves to 1.4550 and you decide to close your trade.

The new quote for USD/CHF is 1.4550 / 1.4555. Since you initially bought to open the trade, to close the trade, you now must sell in order to close the trade so you must take the “BID” price of 1.4550. The price that traders are prepared to buy at.

The difference between 1.4530 and 1.4550 is .0020 or 20 pips. Using our formula from before, we now have:

(.0001/1.4550) x 100,000 = $6.87 per pip x 20 pips = $137.40

What Types of Spreads are in Forex?

The type of spreads that you’ll see on a trading platform depends on the forex broker and how they make money.

There are two types of spreads: Fixed and Variable (also known as “floating”)

Fixed spreads are usually offered by brokers that operate as a market maker or “dealing desk” model while variable spreads are offered by brokers operating a “non-dealing desk” model.

Fixed spreads stay the same regardless of what market conditions are at any given time. In other words, whether the market is volatile like or quiet, the spread is not affected. It stays the same.

Using a dealing desk, the broker buys large positions from their liquidity provider(s) and offers these positions in smaller sizes to traders. This means that the broker acts as the counterparty to their clients’ trades. Having a dealing desk, allows the forex broker to offer fixed spreads because they are able to control the prices they display to their clients.

Fixed spreads have smaller capital requirements, so trading with fixed spreads offers a cheaper alternative for traders who don’t have a lot of money to start trading with. It also makes calculating transaction costs more predictable. Since spreads never change, you’re always sure of what you can expect to pay when you open a trade.

Requotes can occur frequently when trading with fixed spreads since pricing is coming from just one source (your broker). There will be times when the forex market is volatile and prices are rapidly changing. Since spreads are fixed, the broker won’t be able to widen the spread to adjust for current market conditions.

So if you try to enter a trade at a specific price, the broker will “block” the trade and ask you to accept a new price. You will be “re-quoted” with a new price. It’s almost always a price that is worse than the one you ordered.

Variable spreads are always changing. With variable spreads, the difference between the bid and ask prices of currency pairs is constantly changing. Non-dealing desk brokers get their pricing of currency pairs from multiple liquidity providers and pass on these prices to the trader without the intervention of a dealing desk.

This means they have no control over the spreads. And spreads will widen or tighten based on the supply and demand of currencies and the overall market volatility. Typically, spreads widen during economic data releases as well as other periods when the liquidity in the market decreases.

Stop Loss Order

An order to close out if the market price reaches a specified price, which may represent a loss or profit. A stop loss order is a type of order linked to a trade for the purpose of preventing additional losses if the price goes against you.

A stop loss order remains in effect until the position is liquidated or you cancel the stop loss order.

For example, you went long (buy) EUR/USD at 1.1630. To limit your maximum loss, you set a stop loss order at 1.1600. This means if you were dead wrong and EUR/USD drops to 1.1600 instead of moving up, your trading platform would automatically execute a sell order at 1.1600 the best available price and close out your position for a 30-pip loss.

Stop losses are extremely useful if you don’t want to sit in front of your monitor all day worried that you will lose all your money. You can simply set a stop loss order on any open positions so you may attend to your other commitments.

Trailing Stop

A stop loss order which is always attached to an open position and which automatically moves once profit becomes equal to or higher than a level you specify. A trailing stop is a type of stop loss order attached to a trade that moves as the price fluctuates.

Let’s say that you’ve decided to short GBP/USD at 1.3780, with a trailing stop of 20 pips. This means that originally, your stop loss is at 1.3800. If the price goes down and hits 1.3760, your trailing stop would move down to 1.3800 (or breakeven).

Going back to the example, with a trailing stop of 20 pips, if GBP/USD hits 1.3740, then your stop would move to 1.3760 (or lock in 20 pips profit). Your trade will remain open as long as the price does not move against you by 20 pips.

Once the market price hits your trailing stop price, a market order to close your position at the best available price will be sent and your position will be closed.