The 1971 abandonment of the
Bretton Woods Accord and the subsequent
unwinding of the system of fixed exchange rates
gave rise to the foreign exchange market as we
know it today.
Forex refers to the
foreign exchange market, where brokerage firms
and banks are connected over an electronic
network that allows them to convert the
currencies of countries around the globe.
The forex market is the largest and most
liquid financial market in the world. The daily
dollar volume of currencies traded in the
currency market exceeds $1.9 trillion, many
times larger than the combined volume of all
U.S. equities and futures markets.
While
forex trading used to be executed exclusively
between government central banks and commercial
and investment banks, trading forex has become
increasingly accessible to private investors
thanks to the PC and internet.
The most
commonly traded currencies are the US Dollar,
Japanese Yen, Euro, British Pound, Swiss Franc,
Canadian Dollar and Australian Dollar. The FX
market runs 24-hour hours a day, 5 days a week
with continuous access to global dealers.
Trading is not centralized on a physical
location or an exchange, as with the stock and
futures markets.
Foreign Exchange is the
simultaneous buying of one currency and selling
of another. Currencies are traded in pairs, for
example Euro/US Dollar (EUR/USD) or US
Dollar/Japanese Yen (USD/JPY).
For
example, you would execute a trade when you
expect the currency you are buying to increase
relative to the one you are selling. If the
currency you are buying increases in value, you
must sell the other currency to close the
position and take a profit. The first currency
in the pair is called the base currency and the
second is called the counter or quote currency.
Usually the US currency is the base currency and
quotes are given in $1 USD per counter currency,
e.g. USD/JPY. The exceptions are the British
Pound, the Euro and the Australian Dollar.
Understanding forex quotes: 1 unit of
the base curreny = the exchange rate in the
quote currency. I.e. if EUR/USD is trading at
1.2762, 1 Euro will buy you 1.2762 Dollars.
Understanding contract size in forex
trading: The contract size is normally a lot of
100,000. This means per standard contract you
are controling 100,000 units of each pair, so if
you are buying eur/usd you would be buying
100,000 euro's and selling 100,000 dollars
simultaneously. For this contract size, each pip
(the smallest price increment) is worth $10.
Many firms offer mini accounts now where you can
trade units of 10,000, where the pip value is
$1.
Trading the Forex market allows very
low margin requirements relative to other
markets.
The following is an introduction to some
basic terms, definitions and concepts used in
forex trading. It is designed to be read in chronological
order, starting with the most simplest terms
and moving through to some more advanced terms
used in the forex market, or you can click on
any individual term if you want an explanation
of a specific term.
Introduction
Foreign Exchange
The simultaneous transaction of one currency
for another.
Foreign Exchange
Market
The Foreign exchange market is a large,
growing and liquid financial market that
operates 24 hours a day. It is not a market in
the traditional sense because there is no
central trading location or "exchange". Most of
the trading is conducted by telephone or through
electronic trading networks. The primary market
for currencies is the "interbank market" where
banks, insurance companies, large corporations
and other large financial institutions manage
the risks associated with fluctuations in
currency rates.
Spot Market
The market for buying and selling currencies
at the current market rate.
Rollover
A spot transaction is generally due for
settlement within two business days (the value
date). The cost of rolling over a transaction is
based on the interest rate differential between
the two currencies in a transaction. If you are
long (bought) the currency with a higher rate of
interest you will earn interest. If you are
short (sold) the currency with a higher rate of
interest you will pay interest. Most brokers
will automatically roll over your open positions
allowing you to hold your position indefinitely.
Exchange
Rate
The value of one currency expressed in terms
of another. For example, if EUR/USD is 1.3200, 1
Euro is worth US$1.3200.
Currency Pair
The two currencies that make up an exchange
rate. When one is bought, the other is sold, and
vice versa.
Base Currency
The first currency in the pair. Also the
currency your account is denominated in.
Counter
Currency
The second currency in the pair. Also known
as the terms currency.
ISO Currency Codes
USD = US Dollar
EUR = Euro
JPY =
Japanese Yen
GBP = British Pound
CHF =
Swiss Franc
CAD = Canadian Dollar
AUD =
Australian Dollar
NZD = New Zealand
Dollar
For a full list, see ISO Currency
Codes
Currency Pair
Terminology
EUR/USD = "Euro"
USD/JPY = "Dollar
Yen"
GBP/USD = "Cable" or
"Sterling"
USD/CHF = "Swissy"
USD/CAD =
"Dollar Canada" (CAD referred to as the
"Loonie")
AUD/USD = "Aussie
Dollar"
NZD/USD = "Kiwi"
FCM
Futures Commission Merchant. An individual or
organisation licensed by the U.S. Commodities
Futures Trading Commission (CFTC) to deal in
futures products and accept monies from clients
to trade them.
Market Maker
A market maker provides pricing for a
particular currency pair and stands ready to buy
or sell that pair at the quoted price. A market
maker takes the opposite side of your trade and
has the option of either holding that position
or partially or fully offsetting it with other
dealers, managing their aggregate exposure to
the market. A market maker earns their
commission from the spread between the bid and
offer price.
Forex ECN Broker
ECN is an acronym for Electronic
Communications Network. A Forex ECN broker
provides a marketplace where multiple market
makers, banks and traders can enter in competing
bids and offers into the platform either inside
or outside the spread, allowing traders to have
their trades filled by multiple liquidity
providers. A trader might have their buy order
filled by liquidity provider "A", and close the
same order against liquidity provider "B", or
have the trade filled by the bid or offer of
another trader. The best bid and offer is
displayed to the trader with the combined
available volume displayed at each price. An ECN
charges a small fee for each transaction.
Dealing Desk
A dealing desk provides pricing and liquidity
and executes trades.
NDD
An acronym for 'No Dealing Desk'. A
no-dealing desk broker uses external liquidity
providers to provide pricing and liquidity for
its clients. The liquidity providers send in
competing bids and offers into the platform,
resulting in the best bid and offer being
displayed to the client.
Counterparty
One of the participants in a transaction.
Sell
Quote / Bid Price
The sell quote is displayed on the left and
is the price at which you can sell the base
currency. It is also referred to as the market
maker's bid price. For example, if the EUR/USD
quotes 1.3200/03, you can sell 1 Euro at the bid
price of US$1.3200.
Buy
Quote / Offer Price
The buy quote is displayed on the right and
is the price at which you can buy the base
currency. It is also referred to as the market
maker's ask or offer price. For example, if the
EUR/USD quotes 1.3200/03, you can buy 1 Euro at
the offer price of US$1.3203.
Spread
The difference between the sell quote and the
buy quote or the bid and offer price. For
example, if EUR/USD quotes read 1.3200/03, the
spread is the difference between 1.3200 and
1.3203, or 3 pips. In order to break even on a
trade, a position must move in the direction of
the trade by an amount equal to the spread.
Pip
The smallest price increment a currency can
make. Also known as points. For example, 1 pip =
0.0001 for EUR/USD, or 0.01 for USD/JPY.
Pip Value
The value of a pip. Pip value can be either
fixed or variable depending on the currency
pair. e.g. The pip value for EUR/USD is always
$10 for standard lots, $1 for mini-lots and
$0.10 for micro lots.
Lot
The standard unit size of a transaction.
Typically, one standard lot is equal to 100,000
units of the base currency, 10,000 units if it's
a mini, or 1,000 units if it's a micro. Some
dealers offer the ability to trade in any unit
size, down to as little as 1 unit.
Standard
Account
Trading with standard lot sizes, generally
100,000 units of the base currency. e.g. The pip
value is $10 for EUR/USD.
Mini Account
Trading with mini lot sizes, generally 10,000
units of the base currency. e.g. The pip
value is $1 for EUR/USD.
Micro Account
Trading with micro lot sizes, generally 1,000
units of the base currency. e.g. The pip
value is $0.10 for EUR/USD.
Margin
The deposit required to open or maintain a
position. Margin can be either "free" or "used".
Used margin is that amount which is being used
to maintain or open a position, whereas free
margin is the amount available to open new
positions. With a $1,000 margin balance in your
account and a 1% margin requirement to open a
position, you can buy or sell a position worth
up to a notional $100,000. This allows a trader
to leverage his account by up to 100 times or a
leverage ratio of 100:1. If a traders account
falls below the minimum amount required to
maintain an open position, he will receive a
"margin call" requiring him to either add more
money into his or her account or to close the
open position. Most brokers will automatically
close a traders open positions when the margin
balance falls below the amount required to keep
the positions open. The amount required to
maintain an open position is dependent on the
broker and could be 50% of the original margin
required to open the trade.
Leverage
Leverage is the ability to gear your account
into a position greater than your total account
margin. For instance, if a trader has $1,000 of
margin in his account and he opens a $100,000
position, he leverages his account by 100 times,
or 100:1. If he opens a $200,000 position with
$1,000 of margin in his account, his leverage is
200 times, or 200:1. Increasing your leverage
magnifies both gains and losses.
To calculate the leverage used, divide the
total value of your open positions by the total
margin balance in your account. For example, if
you have $10,000 of margin in your account and
you open one standard lot of USD/JPY (100,000
units of the base currency) for $100,000, your
leverage ratio is 10:1 ($100,000 / $10,000). If
you open one standard lot of EUR/USD for
$150,000 (100,000 x EURUSD 1.5000) your leverage
ratio is 15:1 ($150,000 / $10,000).
Manual
Execution
An order which is executed by dealer
intervention.
Automatic
Execution
The order is executed automatically without
dealer intervention or involvement.
Slippage
The difference between the order price and
the executed price, measured in pips. Slippage
often occurs in fast moving and volatile
markets, or where there is manual execution of
trades.
Drawdown
The decline in account balance from peak to
valley, until the account surpasses the previous
high, usually measured in percentage terms.
Support
Support is a technical price level where
buyers outweigh sellers, causing prices to
bounce off a temporary price floor.
Resistance
Resistance is a technical price level where
sellers outweigh buyers, causing prices to
bounce off a temporary price ceiling.
Common Order
Types
Market
Order
An order to buy or sell at the current market
price.
Limit Order
An order to buy or sell at a pre-specified
price level.
Stop-Loss
Order
An order to restrict losses at a
pre-specified price level.
Limit Entry
Order
An order to buy below the market or sell
above the market at a pre-specified level,
believing that the price will reverse direction
from that point.
Stop-Entry Order
An order to buy above the market or sell
below the market at a pre-specified level,
believing that the price will continue in the
same direction.
OCO Order
One Cancels Other. An order whereby if one is
executed, the other is cancelled.
GTC Order
Good Till Cancelled. An order stays in the
market until it is either filled or
cancelled.
Common Trade
Types
Long Position
A position in which the trader attempts to
profit from an increase in price. i.e. Buy low,
sell high.
Short Position
A position in which the trader attempts to
profit from a decrease in price. i.e. Sell high,
buy low.
Common Trading
Styles
Technical
Analysis
A style of trading that involves analysing
price charts for technical patterns of
behaviour.
Fundamental
Analysis
A style of trading that involves analysing
the macroeconomic factors of an economy
underpinning the value of a currency and placing
trades that support the trader's long or
short-term outlook.
Trend Trading
A style of trading that attempts to profit
from riding short, medium or long term trends in
price.
Range Trading
A style of trading that attempts to profit
from buying and selling currencies between a
lower level of support and an upper level of
resistance. The upper level of resistance and
the lower level of support defines the range.
The range forms a price channel where the price
can be seen to oscillate between the two levels
of support and resistance.
News Trading
A style of trading whereby a trader attempts
to profit from fundamental news announcements on
a country's economy that may affect the value of
a currency, usually seeking short term profit
immediately after the announcement is released.
Scalping
A style of trading that involves frequent
trading seeking small gains over a very short
period of time. Trades can last from seconds to
minutes.
Day Trading
A style of trading that involves multiple
trades on an intra-day basis. Trades can last
from minutes to hours.
Swing Trading
A style of trading that involves seeking to
profit from short to medium term swings in
trend. Trades can last from hours to days.
Carry Trading
A style of trading whereby the trader
attempts to profit from holding a currency with
a higher rate of interest and selling a currency
with a lower rate of interest, profiting from
the daily interest rate differential of the
position.
Position Trading
A style of trading that involves taking a
longer term position that reflects a longer term
outlook. Trades can last from weeks to months.
Discretionary
Trading
A style of trading that uses human judgement
and decision making in every trade.
Automated
Trading
A style of trading that involves neither
human decision making nor involvement, but uses
a pre-programmed strategy based on technical or
fundamental analysis to automatically execute
trades via an automated software programme.
Example
Trade
Assume you have a trading account at a broker
that requires a 1% margin deposit for every
trade. The current quote for EUR/USD is
1.3225/28 and you want to place a market order
to buy 1 standard lot of 100,000 Euros at
1.3228, for a total value of US$132,280 (100,000
* $1.3228). The broker requires you to deposit
1% of the total, or $1322.80 to open the trade.
At the same time you place a take-profit order
at 1.3278, 50 pips above your order price. In
taking this trade you expect the Euro to
strengthen against the U.S. dollar.
As you expected, the Euro strengthens against
the U.S. dollar and you take your profit at
1.3278, closing out the trade. As each pip is
worth US$10, your total profit for this trade is
$500, for a total return of
38%.
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