Forex Basics

Forex Basics

The following is an introduction to some basic terms, definitions and concepts used in forex trading. It is designed to be read in chronological order, starting with the most simplest terms and moving through to some more advanced terms used in the forex market, or you can click on any individual term if you want an explanation of a specific term.

Basics

Automatic Execution
Base Currency
Bid
Buy Quote
Counter Currency
Counterparty
Currency Pair
Currency Pair Terminology
Dealing Desk
Drawdown
ECN
Exchange Rate
FCM
Foreign Exchange
Foreign Exchange Market
ISO Currency Codes
Leverage
Lot
Manual Execution
Market Maker
Margin
Micro Account
Mini Account
NDD
Offer
Pip
Pip Value
Resistance
Rollover
Sell Quote
Slippage
Spot Market
Spread
Standard Account
Support
Terms Currency

Basic Order Types
GTC Order
Limit-Entry Order
Limit Order
Market Order
OCO Order
Stop-Entry Order
Stop-Loss Order
Basic Trade Types
Long Position
Short Position
Basic Trading Styles
Automated Trading
Carry Trading
Day Trading
Discretionary Trading
Fundamental Trading
News Trading
Position Trading
Range Trading
Scalping
Swing Trading
Technical Trading
Trend Trading
Example Trade

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Introduction

Foreign Exchange

The simultaneous transaction of one currency for another.

Foreign Exchange Market

The Foreign exchange market is a large, growing and liquid financial market that operates 24 hours a day. It is not a market in the traditional sense because there is no central trading location or “exchange". Most of the trading is conducted by telephone or through electronic trading networks. The primary market for currencies is the “interbank market” where banks, insurance companies, large corporations and other large financial institutions manage the risks associated with fluctuations in currency rates.

Spot Market

The market for buying and selling currencies at the current market rate.

Rollover

A spot transaction is generally due for settlement within two business days (the value date). The cost of rolling over a transaction is based on the interest rate differential between the two currencies in a transaction. If you are long (bought) the currency with a higher rate of interest you will earn interest. If you are short (sold) the currency with a higher rate of interest you will pay interest. Most brokers will automatically roll over your open positions allowing you to hold your position indefinitely.

* How to calculate rollover interest
* Rollovers in Forex

Exchange Rate

The value of one currency expressed in terms of another. For example, if EUR/USD is 1.3200, 1 Euro is worth US$1.3200.

Currency Pair

The two currencies that make up an exchange rate. When one is bought, the other is sold, and vice versa.

Base Currency

The first currency in the pair. Also the currency your account is denominated in.

Counter Currency

The second currency in the pair. Also known as the terms currency.

ISO Currency Codes

USD = US Dollar
EUR = Euro
JPY = Japanese Yen
GBP = British Pound
CHF = Swiss Franc
CAD = Canadian Dollar
AUD = Australian Dollar
NZD = New Zealand Dollar

For a full list, see ISO Currency Codes

Currency Pair Terminology

EUR/USD = "Euro"
USD/JPY = "Dollar Yen"
GBP/USD = "Cable" or "Sterling"
USD/CHF = "Swissy"
USD/CAD = "Dollar Canada" (CAD referred to as the "Loonie")
AUD/USD = "Aussie Dollar"
NZD/USD = "Kiwi"

FCM

Futures Commission Merchant. An individual or organisation licensed by the U.S. Commodities Futures Trading Commission (CFTC) to deal in futures products and accept monies from clients to trade them.

Market Maker

A market maker provides pricing for a particular currency pair and stands ready to buy or sell that pair at the quoted price. A market maker takes the opposite side of your trade and has the option of either holding that position or partially or fully offsetting it with other dealers, managing their aggregate exposure to the market. A market maker earns their commission from the spread between the bid and offer price.

* Example of Market Makers

Forex ECN Broker

ECN is an acronym for Electronic Communications Network. A Forex ECN broker provides a marketplace where multiple market makers, banks and traders can enter competing bids and offers into the platform either inside or outside the spread, allowing traders to have their trades filled by multiple liquidity providers. A trader might have their buy order filled by liquidity provider "A", and close the same order against liquidity provider "B", or have the trade filled by the bid or offer of another trader. The best bid and offer is displayed to the trader with the combined available volume displayed at each price. An ECN charges a small fee for each transaction.

* Example of ECN Brokers

Dealing Desk

A dealing desk provides pricing and liquidity and executes trades.

NDD

An acronym for 'No Dealing Desk'. A no-dealing desk broker uses external liquidity providers to provide pricing and liquidity for its clients. The liquidity providers send in competing bids and offers into the platform, and the broker displays the best available bid and offer to the trader.

* Example of No Dealing Desk Brokers

Counterparty

One of the participants in a transaction.

Sell Quote / Bid Price

The sell quote is displayed on the left and is the price at which you can sell the base currency. It is also referred to as the market maker's bid price. For example, if the EUR/USD quotes 1.3200/03, you can sell 1 Euro at the bid price of US$1.3200.

Buy Quote / Offer Price

The buy quote is displayed on the right and is the price at which you can buy the base currency. It is also referred to as the market maker's ask or offer price. For example, if the EUR/USD quotes 1.3200/03, you can buy 1 Euro at the offer price of US$1.3203.

Spread

The difference between the sell quote and the buy quote or the bid and offer price. For example, if EUR/USD quotes read 1.3200/03, the spread is the difference between 1.3200 and 1.3203, or 3 pips. In order to break even on a trade, a position must move in the direction of the trade by an amount equal to the spread.

Pip

The smallest price increment a currency can make. Also known as points. For example, 1 pip = 0.0001 for EUR/USD, or 0.01 for USD/JPY.

Pip Value

The value of a pip. Pip value can be either fixed or variable depending on the currency pair. e.g. The pip value for EUR/USD is always $10 for standard lots, $1 for mini-lots and $0.10 for micro lots.

* How to Calculate Pip Values
* Pip Value Calculator

Lot

The standard unit size of a transaction. Typically, one standard lot is equal to 100,000 units of the base currency, 10,000 units if it's a mini, or 1,000 units if it's a micro. Some dealers offer the ability to trade in any unit size, down to as little as 1 unit.

Standard Account

Trading with standard lot sizes, generally 100,000 units of the base currency. e.g. The pip value is $10 for EUR/USD.

Mini Account

Trading with mini lot sizes, generally 10,000 units of the base currency. e.g. The pip value is $1 for EUR/USD.

Micro Account

Trading with micro lot sizes, generally 1,000 units of the base currency. e.g. The pip value is $0.10 for EUR/USD.

Margin

The deposit required to open or maintain a position. Margin can be either "free" or "used". Used margin is that amount which is being used to maintain or open a position, whereas free margin is the amount available to open new positions. With a $1,000 margin balance in your account and a 1% margin requirement to open a position, you can buy or sell a position worth up to a notional $100,000. This allows a trader to leverage his account by up to 100 times or a leverage ratio of 100:1. If a traders account falls below the minimum amount required to maintain an open position, he will receive a "margin call" requiring him to either add more money into his or her account or to close the open position. Most brokers will automatically close a traders open positions when the margin balance falls below the amount required to keep the positions open. The amount required to maintain an open position is dependent on the broker and could be 50% of the original margin required to open the trade.

Leverage

Leverage is the ability to gear your account into a position greater than your total account margin. For instance, if a trader has $1,000 of margin in his account and he opens a $100,000 position, he leverages his account by 100 times, or 100:1. If he opens a $200,000 position with $1,000 of margin in his account, his leverage is 200 times, or 200:1. Increasing your leverage magnifies both gains and losses.

To calculate the leverage used, divide the total value of your open positions by the total margin balance in your account. For example, if you have $10,000 of margin in your account and you open one standard lot of USD/JPY (100,000 units of the base currency) for $100,000, your leverage ratio is 10:1 ($100,000 / $10,000). If you open one standard lot of EUR/USD for $150,000 (100,000 x EURUSD 1.5000) your leverage ratio is 15:1 ($150,000 / $10,000).

* Understanding leverage Part I
* Understanding leverage Part II
* Calculate Leverage

Manual Execution

An order which is executed by dealer intervention.

Automatic Execution

The order is executed automatically without dealer intervention or involvement.

Slippage

The difference between the order price and the executed price, measured in pips. Slippage often occurs in fast moving and volatile markets, or where there is manual execution of trades.

Drawdown

The decline in account balance from peak to valley, until the account surpasses the previous high, usually measured in percentage terms.

Support

Support is a technical price level where buyers outweigh sellers, causing prices to bounce off a temporary price floor.

Resistance

Resistance is a technical price level where sellers outweigh buyers, causing prices to bounce off a temporary price ceiling.

Common Order Types

Market Order

An order to buy or sell at the current market price.

Limit Order

An order to buy or sell at a pre-specified price level.

Stop-Loss Order

An order to restrict losses at a pre-specified price level.

Limit Entry Order

An order to buy below the market or sell above the market at a pre-specified level, believing that the price will reverse direction from that point.

Stop-Entry Order

An order to buy above the market or sell below the market at a pre-specified level, believing that the price will continue in the same direction.

OCO Order

One Cancels Other. An order whereby if one is executed, the other is cancelled.

GTC Order

Good Till Cancelled. An order stays in the market until it is either filled or cancelled.

Common Trade Types

Long Position

A position in which the trader attempts to profit from an increase in price. i.e. Buy low, sell high.

Short Position

A position in which the trader attempts to profit from a decrease in price. i.e. Sell high, buy low.

Common Trading Styles

Technical Analysis

A style of trading that involves analysing price charts for technical patterns of behaviour.

* Technical Analysis Books

Fundamental Analysis

A style of trading that involves analysing the macroeconomic factors of an economy underpinning the value of a currency and placing trades that support the trader's long or short-term outlook.

Trend Trading

A style of trading that attempts to profit from riding short, medium or long term trends in price.

* Forex Trend Trading System

Range Trading

A style of trading that attempts to profit from buying and selling currencies between a lower level of support and an upper level of resistance. The upper level of resistance and the lower level of support defines the range. The range forms a price channel where the price can be seen to oscillate between the two levels of support and resistance.

* Article: Identifying Trending & Range Bound Currencies

News Trading

A style of trading whereby a trader attempts to profit from fundamental news announcements on a country's economy that may affect the value of a currency, usually seeking short term profit immediately after the announcement is released.

Scalping

A style of trading that involves frequent trading seeking small gains over a very short period of time. Trades can last from seconds to minutes.

Day Trading

A style of trading that involves multiple trades on an intra-day basis. Trades can last from minutes to hours.

* Forex Day Trading Systems

Swing Trading

A style of trading that involves seeking to profit from short to medium term swings in trend. Trades can last from hours to days.

Carry Trading

A style of trading whereby the trader attempts to profit from holding a currency with a higher rate of interest and selling a currency with a lower rate of interest, profiting from the daily interest rate differential of the position.

Position Trading

A style of trading that involves taking a longer term position that reflects a longer term outlook. Trades can last from weeks to months.

Discretionary Trading

A style of trading that uses human judgement and decision making in every trade.

* Managed Discretionary Accounts

Automated Trading

A style of trading that involves neither human decision making nor involvement, but uses a pre-programmed strategy based on technical or fundamental analysis to automatically execute trades via an automated software programme.

* Automated Trading Systems
* Managed Automated Accounts

Example Trade

Assume you have a trading account at a broker that requires a 1% margin deposit for every trade. The current quote for EUR/USD is 1.3225/28 and you want to place a market order to buy 1 standard lot of 100,000 Euros at 1.3228, for a total value of US$132,280 (100,000 * $1.3228). The broker requires you to deposit 1% of the total, or $1322.80 to open the trade. At the same time you place a take-profit order at 1.3278, 50 pips above your order price. In taking this trade you expect the Euro to strengthen against the U.S. dollar.

As you expected, the Euro strengthens against the U.S. dollar and you take your profit at 1.3278, closing out the trade. As each pip is worth US$10, your total profit for this trade is $500, for a total return of 38%.

Related Links

* Introduction to Forex
* Ask-an-Expert Forum
* Forex Market Snapshot
* Online Money Management Calculator
* Forex Money Management Article
* Free Position Size Calculator

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Risk Disclosure: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.
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