The Foreign Exchange, commonly known as forex, is the global marketplace where international currencies and their derivatives are traded. It is the largest financial market in the world in terms of both size and liquidity.
To give a general idea of the size, an average of over $6 trillion is traded globally each day. No stock market in the world trades such a huge amount daily.
The basic idea of forex is the exchange of one country’s currency for the currency of another country. With forex, you’re essentially buying one currency and selling the other at the same time. As a result, trades on the forex happen in pairs.
For example, the British Pound-US Dollar pair (GBP/USD) refers to the amount of USD one gets for each GBP.
Due to the higher stability and liquidity of certain currencies, some forex pairs are more popular than others. These include the Euro vs. US Dollar (EUR/USD); British Pound vs. US Dollar (GBP/USD); US Dollar vs. Japanese yen (USD/JPY); and US Dollar vs. Swiss Franc (USD/CHF). These four pairs are often referred to as the major currency pairs.
Unlike the stock exchange, the Foreign Exchange market is also decentralised. It has no set physical location. This makes forex an OTC (Over-the-Counter) market, where trades happen directly between two parties without a centralised exchange.
All trades on the forex are processed electronically 24 hours a day between banks around the world. forex, unlike other financial markets, does not have an exchange centre. Instead, there is always a financial centre somewhere in the world open at any point in the day.
The forex market is open 5 days a week and only closes at weekends between 22:00 (GMT) on Friday and 22:00 (GMT) on Sunday. While the forex market is open 24 hours a day, there are some peak trading session times in each region. We have a general outline below:
Quotes in forex
Currencies are always traded in pairs. This is because one currency is valued against another by an exchange rate. An exchange rate is how much you’d have to pay in a quote currency, to get 1 unit of a base currency.
So how does one read an FX quote？
Most sources will display a quote accordingly:
EUR/USD = 1.1200
This means that 1 € = 1.12 $
The Euro, written as EUR, is known as the Base Currency.
The US Dollar, written as USD, is known as the Counter or Quote Currency.
When the US Dollar is the Base Currency, it is often referred to as a Direct Quote in the context of trading.
USD/JPY = 125.00
This means 1 $ = 125 ¥
The US Dollar, written as USD, is known as the Base Currency.
The Japanese Yen, written as JPY, is known as the Counter or Quote Currency.
When the US Dollar is the base currency, it is referred to as an Indirect Quote.
What is a Pip in Forex?
When trading FX, there are several unique terms used. A pip and lot are two of the most basic terms used in forex.
Pip is short for “percentage in point” and is the smallest possible increment in a quote.
A pip refers to 0.0001 of a unit of the quote currency.
For example, the exchange rate of GBP/USD is 1.5696. If it goes up to 1.5697, we will say that the price of GBP has gone up by 1 pip.
This rule applies to every currency except the Japanese yen, for which a pip is 0.01 yen.
For example, USD/JPY is 115.75. If the exchange rate drops to 115.74, we would say that the rate has gone down by 1 pip.
To summarise, a pip is the last decimal place in a quotation. Most currency pairs will have a pip equivalent to 0.0001, with the Japanese Yen being one of the major exceptions at 0.01.
What is a Lot in Forex?
In forex trading, a standard lot is 100,000 units of the base currency. In the case of EUR/USD, one lot is EUR 100,000.
As mentioned previously, a pip refers to 0.0001 of a quote currency. Therefore, one pip of a standard lot equals 10 units of the quote currency.
In the case of EUR/USD, a movement of 1 pip would mean a loss/profit of $10 per lot traded.
If you are down 10 pips on a standard EUR/USD contract you have lost $100.
Some platforms also display what is known as a micro pip, or a pipette, which is 1/10 of a pip.
Explaining the Bid, Ask and Spread
All forex quotes have two prices attached to them, one is the Bid price, and the other is the Ask price.
The bid price applies if you want to sell the base currency. The bid price is the price at which the other party is willing to buy the base currency.
The Ask price applies if you want to buy the base currency. The Ask price is the price at which the other party is willing to sell the base currency.
For example, based on the following quote:
The Bid price is always lower than the Ask price and the difference between the two is known as the Spread.
For example, based on the following quote:
The spread offered on EUR/USD is 1.13065 – 1.13015 = 0.00050 or 5 pips
In Forex, the spread is the difference in price between buying and selling the base currency – this difference is how a market maker or broker makes a profit, since they are buying at a lower price, and selling at a higher one.
Market Makers are liquidity providers that take the counter side to your trade. The spread is variable, and widens with the amount of risk undertaken by the market makers but can also tighten with increased liquidity and vice versa.
What does it mean to go long or short?
In trading lingo, going long into a position means you are buying, while going short means that you are selling. The forex market can move either up or down, and there are ways to profit from either direction.
In FX trading, because currencies are exchanged in pairs, “Going long” means buying the base currency and selling the quote currency.
For example, the current exchange rate for EUR/USD = 1.1300
If you thought that the Euro was going to rise, you would go long on it, meaning that you would buy the Euro in hopes that you can sell it at a higher price once its value has risen.
Say, you enter a long position in the Euro at 1.1300, and the Euro eventually rises in value to 1.1400. Selling the Euro will now net you a profit of $0.01 per unit traded. If you were trading 1 standard lot, you would net a profit of $1000.
“Going short” in FX terms is selling the base currency and buying the quote currency.
It’s what you would do if you thought that the base currency was going to drop.
For example, the current exchange rate for EUR/USD = 1.1300.
If you thought that the Euro was going to fall, you would want to bet against it. You enter a short position on the Euro at 1.1300.
If the Euro falls to $1.1000, closing your position would net you a profit of $0.03 per unit traded. This is because you are essentially buying the Euro at $1.1000 to cover the Euro that you have sold earlier at $1.1300.
If you had shorted 1 standard lot of EUR/USD, you would have netted a profit of $3000 from selling 100,000 euros at $113,000 and covering it with 100,000 euros bought at $110,000.
If it sounds like a lot of money to be moving for a single trade, it is. Retail trading in forex is a relatively modern phenomenon, and standard lots are usually traded by institutional-sized accounts.
Fortunately for beginner traders, forex can be traded in lesser magnitudes. Micro lots, which are worth 1000 units of the base currency, can allow traders to start small and work their way up.
Consequently, 1 pip on a micro lot is worth 0.10 (in the case of most currencies displayed to 4 decimal places); or 10 (in the case of 2-decimal place currencies like the Japanese Yen) of the counter currency.
Leverage and Margin
Most forex trading is done through leverage, especially since most traders will not have the capital required to trade entire standard lots.
In essence, leveraging is borrowing money from a broker to magnify your potential profit. This, however, also comes with the risk of greater losses as well.
How much can one borrow? That depends on your initial capital, and the level of leverage your broker provides.
Leverages are usually expressed as a ratio. For example, a 100:1 leverage ratio means that one can trade $100,000 worth of assets with just $1000 in cash.
This $1000 is also known as the initial margin, which is required by the broker to be held in one’s account as cash. The margin is thus a percentage expression of the total amount leveraged, that one needs to have in their account as a form of collateral.
A 2% margin requirement would mean that you are trading at a leverage ratio of 50:1, while a 1% margin requirement would you that you are trading at a leverage of 100:1.
For example, buying 1 lot of GBP/USD at 1.31971 with a margin requirement of 3.33% (or a 30:1 leverage) will require the following amount of cash in their brokerage account:
100,000 (1 lot) x 1.31971 x 0.0333
Calculating Profit and Loss
Now that you understand what pips and lots are, you can calculate your profit and loss. Doing so is quite straightforward with the following formula:
P&L = Price Movement x Position Size
If you buy 2 standard lots of EUR/USD at 1.1205 and sell at 1.1210, your position size would be 200,000, with a positive movement of 5 pips, or 0.0005.
P/L = (1.1210 – 1.1205) x (100,000 x 2) = $100
Do note that the P&L is always expressed in the quote currency of your trade.
For example, you buy 1 lot of USD/AUD at 1.2917 and sell at 1.2932
P/L = (1.2932 – 1.2917) x 100,000 x 1 = 150 AUD
To convert the profit into USD, divide by the selling price as you’re selling AUD and buying USD
150 AUD/1.2932 = 115.99 USD