Forex Trading Basics

Exchange Rates and Spreads

All currencies are assigned an International Standards Organization (ISO) code abbreviation. In currency trading, these codes are often used to express which specific currencies make up a currency pair. For example, EUR/USD refers to two currencies: the Euro Dollar and the US Dollar.

Exchange Rate

An exchange rate is simply the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.

EUR / USD

Base Currency / Quote Currency

Bid/Ask Price

A currency exchange rate is typically given as a bid price and an ask price. The bid price is always lower than the ask price. The bid price represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency. The following EUR/USD price quote is an example of bid/ask notation:

EUR / USD

1.14345 / 1.14347

Example

The first component (before the slash) refers to the BID price (what you obtain in USD when you sell EUR). In this example, the BID price is 1.14345. The second component (after the slash) is used to obtain the ASK price (what you have to pay in EUR if you buy USD). In this example, the ASK price is 1.14347.

Spread

The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .00005 or 2 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 3rd decimal place (i.e. USD/JPY may be quoted at 119.454/59), in which case 5 pips represents a difference of .005. Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the inter-bank market.

When trading amounts of $1M or higher, the spread obtained in a quote is typically 5 pips. When trading smaller amounts, the spread is typically larger. For example, when trading less than $100,000, spreads of 50-200 pips are common. Credit card companies typically apply a spread of 200-300 pips. Banks and exchange bureaus typically use a spread in the range of 200-1000 pips (in addition to charging a commission).

Buying and Selling

All trades result in the buying of one currency and the selling of another, simultaneously.

Buying ("going long") the currency pair implies buying the first, base currency and selling an equivalent amount of the second, quote currency (to pay for the base currency). It is not necessary to own the quote currency prior to selling, as it is sold short. A trader buys a currency pair if he/she believes the base currency will go up relative to the quote currency, or equivalently that the corresponding exchange rate will go up.

Selling ("going short") the currency pair implies selling the first, base currency, and buying the second, quote currency. A trader sells a currency pair if he/she believes the base currency will go down relative to the quote currency, or equivalently, that the quote currency will go up relative to the base currency.

An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or loss from fluctuations in the price of that currency pair.

Buying/Selling Currency

Cardinal Rule: All trades result in the buying of one currency and the selling of another, simultaneously.

The objective of currency trading is to exchange one currency for another with the expectation that the market rate or price will change such that the currency pair you have bought has appreciated in value relative to the currency you have sold. If the currency you have bought appreciates in value and you close your open position by selling this currency, or effectively buying the currency that you originally sold, then you are locking in a profit. If the currency depreciates in value and you close your open position by selling this currency, or effectively buying the currency you have sold, then you are realizing a loss.

Basic Entry Rules

1. Buying a currency is equivalent with taking a long position in that currency.

2. Selling a currency is equivalent with selling short that currency.

Open Trade

An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or loss from fluctuations in the price of that currency pair.

Currency Spread and Dealing Rates

A currency exchange rate is always quoted for a currency pair. For example, EUR/USD refers to two currencies: the Euro Dollar and the US Dollar.

Direct Rates

Most currencies are traded directly against the US Dollar. The market rates that are expressed for such currency pairs are called direct rates. In most cases, the US Dollar is the base currency pair whereby the quote currency is expressed as a certain number of units per 1 US Dollar. For example, the following rate USD/CAD=1.45100 indicates that 1 USD (US Dollars) = 1.45100 CAD (Canadian Dollars).

Indirect Rates

For some currency pairs, the US Dollar is not the base currency but the counter or quote currency. The market rates that are expressed for such currency pairs are called indirect rates. This is the case with GBP (British Pound or "Cable"), NZD (New Zealand Dollar), EUR (Eurodollar), and AUD (Australian Dollar). For example, the following rate GBP/USD=1.58100 indicates that 1 GBP (British Pound) = 1.58100 USD (US Dollars).

Cross Rates

When one currency is traded against any currency other than the USD, the market rate for this currency pair is called a cross rate. Cross rate is the exchange rate between two currencies not involving the US Dollar. Although the US dollar rates do not appear in the final cross rate, they are usually used in the calculation and so must be known. Trading between two non-US Dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-US Dollar currency. There are a few non-US Dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.


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