Forex Market Basics

This post is part of the free beginners Forex course

The Foreign Exchange currency market comes with its own technical jargon that could be confusing to the average person. Before going any further, it is important to understand some of the basic terms, terminologies and concepts to better understand the forex markets.

Here is what we will learn in this article

  1. Basic forex terms;
  2. Market Terminology;
  3. Common currency pairs;
  4. The dynamics between currency pairs,

Basic Forex Terms:

Exchange Rate: The monetary value of one currency expressed in provisions of another currency. Take for example the AUD/USD at 0.89706. That means that one Australian Dollar is worth 89.706 cents in American Dollars.

PIP (Percentage in Point): A pip is a unit of change in the exchange rate of a currency pair. As a general rule, currencies are priced to the fourth decimal place. A pip is then one unit of the fourth decimal place. The 5th decimal place is known as a fractional pip. The Japanese Yen is an exception. Because the Yen is close to one hundredth of the value of other major currencies, it is only measured to the second decimal place. A pip in this case is therefore one point in the second decimal place.

Bid Price: The price at which the market will buy a currency pair from you is known as the bid price.

Ask Price: The price at which the market will sell a specific currency pair to you is known as the ask price.

You buy at the ASK price and sell at the BID price.

bidask

In other words, when you want to buy at market you buy the “ask price” (1.67156) and sell at the ” bid price” (1.67105)

Spread: The difference between the bid and ask price of a currency pair. In the example of the GBPUSD above the bid is quoted at 1.67105 and the Ask is quoted at 1.67156. The spread or the difference between the two is 5.1 PIP’s.

Leverage: The borrowed capital used in an account that enables a trader to hold a greater position. It is not uncommon for leverage ratios to be 100:1 or even 200:1. This means that for every $1000 invested into an account, one could hold a position of $100,000 or $200,000 respectively. Increasing leverage increases the potential gains, but also amplifies potential losses.

A simple way to calculate your leverage being used would be to divide the total value of your open positions by the total margin balance in your account. If for illustration purposes, you had funded your trading account with $1,000, and then proceeded to open one standard lot of USD/CAD for $50,000, your leverage ratio would be 50:1 ($50,000/$1,000).

Margin: This is the capital requirement needed to open a position and to hold that position. Margin is considered to be either “used” or “free”. As one would expect, “used” margin is that sum which is in play in the markets. “Free” margin is that which remains at the disposition of the investor to create new open positions. Take for example an investment account with a 100:1 leverage ratio. In this case, a 1% margin level is required to be able invest 100 times that. So, with a $1,000 margin balance, one can hold positions of up to $100,000.

Margin Call: It is important to be aware of the minimum margin amount required to hold an open position. If your account falls below the minimum amount most brokers will automatically close the trade position. They may also prompt for additional funds to be transferred into the trading account. The actual amount/percentage of the account required varies from broker to broker.

Some Basic Market Terminology

Bull Market: Upward bias to the market direction. May also be heard as the “bulls” are in control of the market and driving prices higher.

Bear Market: Downward bias to the market direction. May also be heard as the “bears” are in control of the market and driving the prices lower.

What is great about the Forex market is that profits can be made just as easily in a bull market as in a bear market. Now let us discuss the difference between going Long and going Short.

Long – When a person goes long on a currency pair, they are buying the first currency, the base currency, and selling the second one, the quote currency. So if someone buys the USD/CAD and the American Dollar appreciates in relation to the Loonie, then that person will be in a profitable position.

Short – When a person goes short on a currency pair, they are buying the second currency, the quote currency, and selling the first, the base currency. So if a person sells the USD/CAD and then the American Dollar appreciates in relation to the Loonie, then that person will have suffered a loss in that position.

Below we will review all the possible order types. In the Forex market all trades are called ‘orders’. There are a variety of order types and they can differ between brokers. All brokers have the common basic order types, but then some brokers have some more special types as well.

Market Order – An order that is placed at the price of the market is considered to be a ‘market order’.

Limit Entry Order (Limit Orders) – A limit entry order puts a restriction on the order to the price that the trader decides he is willing to accept. When buying, a limit order can be placed below the market value and when selling a limit order can be placed at a premium to the current market price.

forex buy and sell

Stop Loss Order – A stop loss order is used in conjunction with an open position in the market. It is tied to the open position and automatically sells off that position once the market reaches a certain predetermined level. In currency trading, this is one of the most important tools available. It restricts the risk you are willing to accept and limits potential losses. In essence, this is your trading insurance policy and should always be used.

Trailing Stop – A trailing stop loss order is similar to the stop loss order. It restricts the level of risk one is willing to accept and sells off the position when the market reaches the determined point. The trailing stop differs however in that it follows the market trend. For example, you can set a trailing stop of 20 pips on the USD/CAD. If the market rises by 25 pips, then the trailing stop will also rise by 5 pips. This enables you to guarantee a certain amount of profit as the market rises.

Good till Cancelled Order (GTC) – A GTC order is self-explanatory. It is an order that will subsist until you manual change it or cancel it. It is important to pay close attention to these types of orders. It is not advisable to have outstanding orders for excessive periods of time.

Good for the Day Order (GFD) – A GFD order is only valid for the day’s trading period. The day end for Forex trading is at 5:00pm EST (New York time). It is important to always check the expiry time of a GFD because it may vary from broker to broker.

One Cancels the Other Order (OCO) – An OCO order is a pair of orders placed simultaneously. If one order gets filled then the other one is automatically cancelled. These orders typically combine a limit order with a stop order. For example, if you buy the USD/CAD currency pair and expect it to rise by 50 pips, then you can place a sell order at the limit of plus 50 pips. If at the same time, you are not willing to lose more than 20 pips, then a stop loss order will be placed at that level. Whichever mark is reached first will fulfill the concurrent order and subsequently the other outstanding order will be cancelled.

One Triggers the Other Order (OTO) – An OTO is the inverse of an OCO. In this case, a second order is contingent upon a first order being fulfilled.

What Are The Major Forex Currencies?

currencies

USD    = United States Dollar

EUR    = Euro

GBP    = British Pound

JPY     = Japanese Yen

CAD   = Canadian Dollar

AUD   = Australian Dollar

CHF    = Swiss Franc

NZD    = New Zealand Dollar

Common Currency Pairs and Their Nicknames

EUR/USD       = “Eurodollar”

GBP/USD       = “Sterling”

USD/CAD      = “Dollar Can” (CAD is also referred to as the “Loonie”)

USD/JPY        = “Dollar Yen”

AUD/USD      = “Aussie Dollar”

NZD/USD      = “Kiwi”

USD/CHF       = “Swissy”

Comprehending the Dynamics of a Currency Pair

Before going any further, you must learn how to properly read a currency pair quote.

The exchange rate of a currency is always quoted as a pair of two currencies. The USD/CAD is such an example. When you purchase a currency pair, you are buying one currency and selling another. In this case you would be buying USD and selling CAD.

In this illustration, the USD would also be known as the “Base Currency”. Also known as the domestic currency and the accounting currency, it is the first currency in a pair and is to the left of the slash mark. Our second currency located to the left of the slash mark, the CAD, is also known as the “Quote Currency”. The price is indicative of how much quote currency is required to purchase one unit of the base currency. If you were to sell this pair, you would get 1.11047 CAD for every 1 USD sold.

The whole goal of Forex trading is to buy a currency pair in which you think the Base currency will appreciate in value in relation to the Quote currency. You can also sell a currency pair. In that case you would want the Quote currency to appreciate in value in regards to the Base currency.

FX Swap

Swap rates are determined by the overnight interest rate differential between two currencies involved in the pair. For instance, if you hold AUD/JPY overnight (usually 0:00 server time) you will be paid a swap because the interest rate in Australia is greater than in Japan. If on the other hand, you were selling AUD/JPY you would be paying the swap. However, be advised that some currency pairs will have negative swaps on both the long and short side. Swap rates differ from broker to broker, however, if you would like to see the current swap rates, see here.

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About The Author

Chris Ferreira

My mission is simple: provide the best content and value to aspiring traders so they can learn how to trade the markets like a pro. You can learn some of our strategies for free by subscribing to our email list here