Don’t know how to start? Learn the basic Forex terms
Forex is an English abbreviation for Foreign Exchange, but “FX” or currency or foreign exchange market are also common terms. In the forex market, one currency is exchanged for another with a view of investment. Trade is conducted 5 days a week, 24 hours a day. Approximately $ 6 trillion is traded in one day.
Advantages of Forex vs. other markets
This is the most liquid market. Virtually it is impossible for you not to find an offer for your demand to buy a currency or vice versa a demand for currency you want to sell.
The exchange rates generally do not change over a business day by more than 15%. At the time of Brexit’s announcement on June 14, 2016, the GBP/USD dropped from 1.49989 to 1.32263, i.e. 11.8%. (Note: a 11.8% drop in the exchange rate can cause serious losses to the forex trader, especially if they trade “on leverage”).
The market is not governed by any authority and is not subject to speculations
No speculator is big enough to affect the exchange rate. The only one who can afford it are the central banks, but the interventions cannot last indefinitely.
No insider trading
In the stock market, it can be much easier (even despite various bans) to trade based on confidential information. For example, a business director and 10 other board members know that the company will have to report an unexpectedly high loss. And he knows this a few months ahead. If any member of the board of directors communicates this information to their friend and he/she checks for a decline (however criminal such act would be), it will be reflected on stock exchange rates of the company prior to the announcement of the shares.
What are currency pairs?
The currencies are always traded in “currency pairs”. Why is that? Imagine that you go to the market and want to buy the necessary food. The value will be expressed in the currency that is paid on the given market (in the Czech Republic it would be the Czech crown). Since the value of the currency needs to be expressed in Forex, we need another currency.
In order to buy one currency, you need a second currency (or, in theory, the goods you import into the country in which the desired currency is traded). The currency pair is denoted by currency shortcuts (e.g. EUR is the euro, US dollar is USD).
Therefore, the currency pair consists of two currencies and is divided into “base” and “denomination”. Base currency is a currency that is a means of trade and is always on the left. The base currency is purchased or sold for denomination. This is always shown to the right of the slash.
For example, when trading with a EUR/USD currency pair we buy a dollar for the euro or sell the euro for a dollar. Since the base currency is usually the stronger one, in case of the base currency you can also encounter a term for the base currency. However, there are cases where the stronger currency is listed as denomination (AUD/USD, NZD/USD or USD/CAD).
Market position indicates the status of your transactions and your current exposure to the risk of a decrease or growth in currency rates. An open position means that you have purchased or sold a certain currency, but you have not yet closed it. This means that you are at risk of change in the exchange rate.
Trading long and short positions
The client can open a long or short position based on his/her individual expectations on the market.
If the client expects the price of the underlying asset to rise, the client may open the “buy” position (also known as “long” in English). The client opens a trade with a long position, speculating on the rise in the price of the financial instrument.
Example of a long position
If the client thinks gold is likely to strengthen against the dollar, he/she may choose to buy a CFD for gold (always keep in mind that by CFD trading the client does not buy/sell the real commodity but only speculates on the price movement of the underlying asset).
If the client expects the price of the underlying asset to fall, the client may open the “sell” position (also known as “short” in English). The client opens a trade with a short position, speculating on the decline in the price of the financial instrument.
An example of a short position
If the client thinks oil is likely to fall against the US dollar, he/she may choose to sell a CFD for oil (always keep in mind that by CFD trading the client does not buy/sell the real commodity but only speculates on the price movement of the underlying asset).
The price at which the base currency is purchased or sold is the exchange rate. The exchange rate is given in more than one decimal place, usually four or even five. The exception are currency pairs where there is a significant difference between the value of the base currency and the denomination.
Pip is one of the most common concepts for Forex trading. It is a unit of measurement to express the change in value between two currencies.
For example: “Yesterday the euro-dollar moved by 40 pips.” For most currency pairs, the pip value is 0.0001. Thus, the number of pips indicates the movement in the fourth decimal place. If the EUR/USD exchange rate was 1.21315 and we say it has hovered by 40 pips, the resulting value is 1.21715 or 1.20915. In the first case, the euro strengthened against the dollar by 40 pips; in the second case the euro weakened against the dollar by 40 pips. Note that pip is always denomination. In our case, 1 pip of the EUR/USD currency pair is worth $ 0.0001.
In order to keep your profit or loss constantly under control, it is always necessary to keep in mind the pip value.
Pip value calculation
Let’s say that you buy 100,000 British pounds for a US dollar (1 standard lot). In the following example, forget the Bid and Ask prices. The rate at which you purchased was 1.2164. Now the rate will increase by one pip to 1.2165 and you will be selling for that price. What will be your profit? You’ll get $ 10 in the trade.
You bought £ 100,000, which cost you $ 121,640. You sold them back to the dollars and you earned $ 121,650. The difference between the price for which you sold and the price for which you purchased was 121,650 – 121,640, or $ 10. Since the exchange rate rose by one pip and we traded £ 100,000 (one lot), these $ 10 are worth one pip.
One pip always has a value that is calculated as the transaction volume divided by 10,000. In our case, 100,000 divided by 10,000 = 10. Since we trade a GBP/USD pair, it’s $ 10 (remember that the other currency in a pair – the denomination – always expresses the value of the trade). Bear the value of one pip in mind, if you follow the exchange rate development.
If we trade in larger volumes (even thanks to a lever), the value of the pip can be very high. That’s why on the forex market one can earn as well as lose very quickly.
Another frequent term is a lot. In the financial vocabulary, a lot refers to a standardized volume of a financial instrument traded on a given market. Traded quantities are not listed as the number of units, for example stock market shares, but in lots. The value of one lot is defined for each market. Lots are mainly used to avoid manipulation with large numbers.
As an example, imagine that you are organizing a summer concert and you are really buying a lot of alcohol. When you order beer, you will not talk about 10,000 beer bottles, but you order 100 beer barrels. On the financial market, a lot is similar to a barrel in the beer market. At Forex, one lot has a value of 100,000 units of base currency. As an example, imagine that the EUR/USD currency pair has one lot worth EUR 100,000. This lot is sometimes referred to as the standard lot. The purchase value of one lot is equal to the purchase worth EUR 100,000 × USD exchange rate.
Bid, Ask and Spread
If we start trading in the financial market, we find that for each currency pair, the trading platform offers 2 prices – Bid and Ask. Bid is the highest possible price at which it is currently possible to sell the asset you own on the market. In the case of the EUR/USD currency pair, this is the price in dollars for which you can sell your euro.
Ask, on the contrary, is the lowest possible price at which you can buy the asset. In our case the price in dollars for which you can buy euros.
The term “spread” refers to the difference between Bid and Ask. Spread (or a larger part of it) is the broker’s profit. If you buy and sell at one point, you will lose an amount equal to the difference between the Bid and the Ask price, that is, the spread. This difference has been held by the broker as a brokerage commission.
A lever on the forex market makes trading more interesting, but also riskier. It is an instrument that makes Forex an opportunity for very quick profits but also a loss of money. If the client puts in $ 1000 and we assume that his leverage is 1:50, the highest amount he can trade with is $ 50,000. The ratio of 1:50 means that to open the position the initial margin is fifty (50) times lower than the transaction size.
In order to trade $ 100,000, Forex does not need to have the full amount. In order to close a business, you only have to have e.g. 1% and even less of the total volume. How is it possible? Your broker can lend you.
Imagine that you deal with the EUR/USD currency pair. You will buy EUR 100,000 at the exchange rate of e.g. 1.0982 and leverage 100:1, but you only need $ 1,098.2 and not $ 109,820. When the exchange rate increases to 1.1000, you earn 18 pips × 10, that is $ 180, which is roughly 16.4%. The average daily fluctuation in Forex is 50 to 60 pips on quiescent days, but on volatile days it can leap up to 100 pips and more.
If the rate dropped by 60 pips in the above example, you would lose $ 600, more than half of your investment. Therefore, it is necessary to learn techniques to work with limiting possible losses, for example by using “Stop-Loss” commands.
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