Forex Currency Trading Basics - Part 1

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: .9726 / .9731

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 .9726. 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 .9731.

Spread

The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .0005 or 5 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 2nd decimal place (i.e. USD/JPY may be quoted at 119.45/50), in which case 5 pips represents a difference of .05. 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 lose from fluctuations in the price of that currency pair.

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Forex vs. Equities

f you are interested in trading currencies online, you will find that the Forex market is significantly different from the equities market.

24-Hour Trading

Forex is a true 24-hour market. Whether it's 6pm or 6am, somewhere in the world there are always buyers and sellers actively trading foreign currencies. Traders can always respond to breaking news immediately, and P&L is not affected by after hours earning reports or analyst conference calls.

After hours trading for U.S. equities brings with it several limitations. ECN's (Electronic Communication Networks), also called matching systems, exist to bring together buyers and sellers - when possible. However, there is no guarantee that every trade will be executed, nor at a fair market price. Quite frequently, traders must wait until the market opens the following day in order to receive a tighter spread. OTC cash foreign exchange is not traded on an organized exchange like the New York Stock Exchange or other instutionalized stock exchanges. The OTC market and its inherent liquidity moves around the world on a continuous basis and is not "closed" during the week to allow for different day sessions and overnight sessions. The OTC market is based on the global market pricing for currencies made by banks and foreign exchange dealers. The majority of global foreign currency dealers and banks are compensated on the difference between the bid/ask spread in the currency price offered to participating traders and/or the ability to accumulate positions on a proprietary basis and assume the risk of the net open positions they carry. Trading in the foreign exchange markets involves the very significant risk of loss and individual traders should only use true discretionary capital for trading. The leverage offered in foreign exchange, which is typically much greater than that offered in the equities market, can work in the trader's favor if the trader is right and can work significantly against the trader if the trader is wrong. Traders should be aware of all the risks associated with trading in the foreign exchange market before trading and should take the time to educate themselves on the risks associated with such trading. Since the foreign exchange market is a global dynamic market place traders must realize that there is no way to eliminate risk and learning how to take and manage risk is an essential part of trading.

Superior Liquidity

With a daily trading volume that is 50x larger than the New York Stock Exchange, there are always broker/dealers willing to buy or sell currencies in the FX markets. The liquidity of this market, especially that of the major currencies, helps ensure price stability. Traders can almost always open or close a position at a fair market price.

Because of the lower trade volume, investors in the stock market are more vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transacti

100:1 Leverage

100:1 leverage is commonly available from online FX dealers, which substantially exceeds the common 2:1 margin offered by equity brokers. At 100:1, traders post $1000 margin for a $100,000 position, or 1%. While certainly not for everyone, the substantial leverage available from online currency trading firms is a powerful, moneymaking tool. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day. The most effective way to manage the risk associated with margined trading is to diligently follow a disciplined trading style that consistently utilizes stop and limit orders. Devise and adhere to a system where your controls kick in when emotion might otherwise take over.

Lower Transaction Costs

It is much more cost-efficient to trade Forex. Most Forex Brokers offer traders access to all relevant market information and trading tools as part of their free services. In contrast, commissions for stock trades range from $7.95-$29.95 per trade with online discount brokers up to $100 or more per trade with full service brokers.

Another important point to consider is the width of the bid/ask spread. Regardless of deal size, forex dealing spreads are normally 5 pips or less (a pip is .0005 US cents). In general, the width of the spread in a forex transaction is less than 1/10 that of a stock transaction, which could include a .125 (1/8) wide spread.

Profit AND LOSS Potential In Both Rising And Falling Markets

Profit and Loss Potential In Both Rising And Falling Markets In every open FX position, an investor is long in one currency and short the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists for both profits and losses in a rising as well as a falling market.

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