Forex Trading Basics
Forex Trading Basics
Making Sense Of Quotes And Pairs
When you see a forex price quote, it will always involve two currencies. That is because all currency transactions are exchanges: you are buying one currency and selling another at the same time. In theory you could trade any two currencies of the world, but most trading involves the currencies of the larger financial powers. This does not necessarily mean the biggest or most politically powerful countries.
Switzerland is only a small country but it is a major player in the financial markets because of the global importance of the Swiss banks.
There are 6 major forex pairs which together account for 90% of the funds traded on the forex markets. These are:
- EUR/USD: the euro and US dollar.
- GBP/USD: the British pound and US dollar.
- USD/JPY: the US dollar and Japanese yen.
- USD/CHF: the US dollar and Swiss franc.
- AUD/USD: the Australian dollar and US dollar.
- USD/CAD: the US dollar and Canadian dollar.
The US dollar is involved in 85% of forex trades and therefore it is in all of the major pairs. Pairs that do not involve USD, such as EUR/GBP, are called cross rates.
The Best Pair For Beginners
The best currency pair for most beginners to trade is EUR/USD. There are two reasons for choosing this pair:
1.It is the most commonly traded pair so liquidity is high and the spread (your cost) is generally low.
2.There is plenty of information available about both currencies. Brokers will supply full charts and it is easy to access financial news and alerts.
You may have access to a particular system that works with another pair. That is fine, but try to stay with only one pair when you are starting out. Do not follow a system that involves trading a lot of different currencies. It is too difficult to keep on top of all of the prices, trends and news.
Understanding A Forex Quote
The first thing to know about currency pairs is that they are always written in a certain order. The first currency is called the base currency and the second is called the quote currency.
Here is an example of a foreign exchange rate for the euro against the US dollar:
EUR/USD 1.3642 1.3644
The base currency is the euro and the quote currency is the dollar. There are two prices given. The first is the bid price, which tells you how many units of the quote currency (USD) you will get when you
sell one unit of the base currency (EUR). In this example you get 1.3642 dollars when you
sell 1 euro.
The second price is the ask price, which tells you how many units of the quote currency (USD) you have to pay to buy one unit of the base currency (EUR). In this example you have to give 1.3644 US dollars to get 1 euro.
If you buy the EUR/USD pair you are buying euros and giving dollars. Buying is called ‘going long’ or ‘taking a long position’.
If you sell EUR/USD you are selling euros and getting dollars. Selling is called ‘going short’ or ‘taking a short position’.
This is the way that traders refer to their transactions. They never talk about ‘exchanging euros for dollars’. Instead they will talk about ‘selling EUR/USD’, or ‘going short on EUR/USD’.
You buy the pair when you believe the base currency (EUR) will increase in value relative to the quote currency (USD). You would sell the pair if you think the base currency will decrease in value relative to the quote currency. Often you will see rates quoted online with just one price given. The second price will vary from broker to broker depending on their spread.
Let’s look at that next.
Spread And Pips
Look again at this example: EUR/USD 1.3642 1.3644
If you were paying attention to the explanation of the bid and ask prices above, you probably realized that if you first buy and then sell again with no change in these prices, you lose $0.0002 (0.02 of a cent) on each dollar that you trade. This is called the spread and it is how the brokers make their money.
The spread is measured in pips. Later, you will also see how to measure your profits in pips.
Why do we need to think in pips?
The reason is simple.
In the foreign exchange market there is not a common currency in which to express values. The US dollar may be the most frequently traded currency but it is not involved in all trades. If you are trading cross rates, i.e. two other currencies such as EUR/GBP or any other combination that does not involve USD, it would not make any sense at all to express your gains and losses in terms of US dollars. Instead, we need something that is a small percentage of the value of whatever currencies we are dealing with. We call it a pip: percentage in point (or some say, price interest point). One pip is the smallest part of a unit that is recorded in the price.
Commonly a price is quoted to 4 decimal places so 1 pip is 0.0001 units of the quote currency. Some brokers are now quoting 5 places, and the Japanese yen is usually quoted to just 2 places, but for our EUR/USD example we will stay with 1 pip = 0.0001.
Here the bid price is 1.3642 and the ask price is 1.3644. So the spread, the difference between them, is 0.0002 or 2 pips. Since the quote currency is US dollars, the pip value in this example is US $0.0001 and the spread is US $0.0002.
$0.0002 may not seem much but in forex trading you will use leverage to deal in lots which could be $10,000 or even $100,000 each. The spread would be $2 per lot in the first case or $20 in the second.
That cuts into your profits. So you do need to take the spread into account when trading.
Always remember that the price must change in your favor by more than the amount of the spread before you will make a profit.
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