Easy Forex

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Forex 101: Basic Concepts and Terms

We have quite a lot to cover here, and I want to make sure the information is presented in a way that helps you absorb it quickly, while still getting a solid, 'big picture' view of how Forex works for individual retail traders.

Therefore, I'm going to use a 'building-block' approach - starting from the simplest example of currency exchange that most people are familiar with - then moving one step at a time to paint a picture of a single retail trade.

So, let's begin with the transaction most people are familiar with - that of exchanging one currency for another when traveling overseas.

Imagine that you're going on a trip to France. You have $1,000 U.S. dollars to spend on food, transportation, souvenirs and tours. You're a smart traveler, though, so you don't want to carry all of that $1,000 as cash in either currency.

Instead, you put $500 into traveler's checks for safe keeping, and convert the remaining $500 into Euros (the Franc was replaced by the Euro at the formation of the European Union, of which France is a member).

On the actual day that you go to get your money converted, the foreign exchange rate is set at 1 US Dollar = 0.68679 Euro. This rate is the official, interbank rate for strict cashto-cash conversions.

After you do the math, you see that your $500 in U.S. Dollars turns into a mere $343.397 Euro. Ouch! You've just taken a hit to the tune of $156.60 right off the bat in term of buying power, even though you haven't spent a cent.

What happened?

What's happened is that the Euro was stronger than the Dollar at the time you made the exchange. Your Dollar wasn't worth as much as the Euro. Therefore, you could not purchase 500 Euro with 500 Dollars.

Keep in mind, however, that this wouldn't necessarily limit your buying power. How much you have to spend while in France depends on the cost of living. For example, if the equivalent of a $15 meal in the U.S. is only $12 in France, you may save enough to offset the hit you took on the exchange rate.

Now, remember that you're a smart traveler. You keep up with the financial markets, and check the exchange rate each day of your trip. On the third day, you notice that the Dollar is 9 continuing to weaken against the Euro.

 

You decide to go ahead and cash out your traveler's checks before things get any worse, at a rate of 1 US Dollar = 0.67679 Euro. This gives you $338.395 additional Euro.

By the time your trip ends, you've spent most of the $343.39 you came with, but still have the $333.39 you converted from traveler's checks. Let's say you've got an even 400 Euro with you on the trip home, just to make things easy.

You put the money away when you get home, and keep watching the market. A few weeks go by.

Suddenly, the news reports that a major mid-east oil deal has rallied and strengthened the Dollar, bringing the exchange rate to: 1 US Dollar = 0.72679 Euro. Bingo! It's time to dig those 400 Euros out of the sock drawer, and go buy back your Dollars.

After the exchange is done, you have $550.36. Don't forget - you started off with $1,000 and lost $156.60 of it right off the bat, leaving you with the equivalent of $843.40. You spent $449.64 of that on your trip, so you should technically only have 393.76 left.

You don't, though. You have $550.36 because the Euros you came home with bought back more dollars than you originally held.

 

This represents the simplest profit on an exchange of currencies, as well as the most elemental idea behind the Forex concept: buy low and sell high.

Now, while this example is representative, it is not entirely accurate. Real trades on the Forex market are often much more complex than this for anyone who wants to turn a serious profit.

Gains are made by trading far larger amounts of money, on far slimmer margins - and by exchanging multiple currencies at a time.

 

Concept #1: Exchange Rates

 

As you saw from the example above, the exchange rate can be defined as the price of one currency in relation to another.

 

A fixed exchange rate, like the one established in 1944 by the Bretton Woods Accord, is an official rate set by monetary authorities (and sometimes governments).

 

Fixed rates are typically set to a pre-determined value (e.g., the price of an ounce of gold), and allowed only slight fluctuation.

 

A floating exchange rate is what is in effect on the foreign exchange market today. This type of rate is not set to any outside reference point.

 

¹⁰ Rather, the rate is determined by the market forces of supply and demand.

Although our earlier example used just two currencies, the Dollar and the Euro, it is important to note that you must NOT view Forex trades as a simple one-to-one transaction.

Not if you want to make any real money, that is. Forex trading is not as easy as buying $10,000 worth of U.S. Dollars with $5, 000 worth of Euros after a market correction.

This doesn't mean you can't achieve these kinds of gains, but you must understand that the majority of successful trades on the retail level involve a well-planned strategy based around buying and selling multiple currencies at a time - not just one or two.

This brings us to our next concept: Currency Pairs
Concept #2: Currency Pairs

When you buy stocks on the Stock Exchange, you have the option of buying the stock of a single company at a time, or multiple companies at a time. You may also choose to sell your stock back right away, or hold it for an indefinite period of time.

The value of stock from a company like Microsoft, for example, is determined largely by that company's performance (profits, meeting quarterly goals, etc), and not directly affected by the performance of other corporations.

The foreign exchange market works a little bit differently.

The value of any currency on Forex is determined in relation to the value of all other currencies. In other words, the value of 1 U.S. dollar changes based on whether you are comparing it to the Euro, the Australian dollar, the Japanese Yen and so on.

The buying and selling of any of these currencies is always done in what's known as currency pairs.

A currency pair consists of a base currency and a quote currency. The base currency is the currency you intended to purchase. The quote currency is the currency you intend to use to purchase the base currency.

Together, the pair shows you how much of the quote currency is needed to buy one 'unit' of the base currency.

 

To illustrate this, let's look at some exchange rates for December 15^th, 2007. We'll compare the U.S. Dollar against the Euro, Canadian Dollar and Japanese Yen:

 

₁₁ 1 EUR = 1.44245 USD / 1 USD = 0.693265 EUR

 

1 CAD = 0.9830391 USD / 1 USD = 1.01720 CAD 1 JPY = 0.00882807 USD / 1 USD = 113.275 JPY

 

The pairs are as follows:

 

EUR/USD = 1.4 - selling Euros to buy Dollars USD/EUR = 0.69 - selling Dollars to buy Euros

 

CAD/USD = 0.98 - selling Canada Dollars to buy U.S. Dollars USD/CAD = 1.01 - selling U.S. Dollars to buy Canada Dollars

 

JPY/USD = 0.0088 - selling Yen to buy Dollars USD/JPY = 113.27 - selling Dollars to buy Yen

Notice that the currency being sold is listed first. The EUR/USD pair tells you that for every Euro you sell, you are purchasing 1.4 U.S. Dollars. Likewise, the USD/EUR pair tells you that for every Dollar you sell, you are purchasing 0.69 Euro.

You are always buying and selling simultaneously when you trade currency on Forex.

Now, let's say that you wanted to turn a profit in U.S. Dollars by trading in these currencies? In an ideal scenario, you would already be holding Euros in your online trading account, and you would have purchased these Euros on a day when the dollar was stronger.

For example, let's say you bought 1,000 Euro when the exchange rate was USD/EUR = 1.40.

 

This means that every $1 you spent purchased 1.4 Euros. In order to buy 1,000 Euros at that rate, you had to spend 1000 X 1.40 = $1,400 U.S. Dollars.

 

Make sense?

Now, let's say you held onto those Euros until the exchange rate went up to USD/EUR = 1.44. You wouldn't want to buy the EUR/USD pair (selling your Euros to buy Dollars) because you would lose money, right?

Instead, you look for something like the Japanese Yen, which is valued far below the Dollar, and then you think: “If the Euro is worth more than $1, then I can buy more Yen with Euros than I can with Dollars. Then, I can take advantage of the Dollar's strength against the Yen.”

So, you buy the Yen with the Euro and then sell the Yen back to buy Dollars.

 

Let's do the math: 12

 

EUR/JPY = 163.3

 

1,000 EUR X 163.3 = 163,300 JPY

 

JPY/USD = .0088

 

163,300 JPY X .0088 = $1,437.04 USD

 

$1,437.04 - $1,400 = $37.04 Total Profit

 

I want you to be able to follow this, so let's recap what happened...

 

First, you traded the EUR/USD pair at a time when $1,400 U.S. Dollars could buy you 1,000 Euro. You held it and waited for both the Dollar and the Euro to rise against the Yen.

 

Then, you traded the EUR/JPY pair, effectively buying more Yen with Euros than you could with Dollars.

 

Finally, you traded the JPY/USD pair, and gained enough margin (via the purchasing power of the Euro) to gain a $37.04 increase on your original investment of $1,400 USD.

 

You effectively leveraged a series of currency pairs in order to profit. This is what I meant when I told you that Forex trading is never as simple as a one-to-one transaction!

There's one thing slightly off with the example I gave you above, though. You'll notice that I shortened the quotes by a few decimals places? I did so for the sake of making the math easier to follow.

However, when trading any currency pair, you must remain mindful of the full exchange rate, all the way down to the last decimal.

 

Remember when I said that most profits on Forex are made by trading on volume, and at very slim margins?

 

Even the slightest change in one of those numbers can have an impact.

 

This brings us to our next fundamental concept: The 'Pip'.

 

Concept #3: 'Pips'

What the heck is a 'pip'? A pip, in Forex terms, is defined as the smallest price change an exchange rate can make. Most of the currency pairs you trade will be quoted out to four decimal places, and a shift in any of those decimals reflects a shift in price.

A 'standard' pip is equivalent to 1 Basis Point or 1/100^th of 1%.
¹³ Again, however, most currencies (with the exception of the Yen) are quoted to four places, which means that shifts can occur in the thousandth and ten-thousandths place. Therefore, for most major currencies:
1 Basis Point = 1/10000^th of 1% = 1 Pip

 

While the Japanese Yen, which is only quoted to the hundredths place follow the traditional definition of:

 

1 Basis Point = 1/100^th of 1% = 1 Pip

 

This is not cut and dry, though. The actual value of a pip can be fixed or variable, depending on:

1) The currency pair being traded
2) The base currency used in your trading account.
3) The lot size of your trade.

Now we have a new term to define before we proceed: What is 'lot size'?

Lot size refers to the size of your transaction or 'contract'. Again, trading on Forex is all about volume. Almost no one trades unit for unit, or 'dollar for dollar', although some brokers do allow this.

The typical lot size for most trades, though, is in multiples of ten:

ü A Standard Lot = 100,000 units of the base currency ü A 'Mini' Lot = 10,000 units of the base currency ü A 'Micro' Lot = 1,000 units of the base currency

Calculating Pip Values

 

This is one area where new investors can become very confused. This is because pip values are dependent on multiple variables.

 

The standard definition says that a pip is equal to a change of 1/100^th in the value of a currency, but this change is not measured solely against the previous value of the currency!

Instead, one must take into account whether the currency pair in question has a fixed value or a variable value relative to the lot size. Further, one must take into account how many decimal places are quoted for the pair.

As you saw earlier, the EUR/USD pair is typically quoted to 4 decimal places, such that if 14

 

the exchange rate were to shift from '1.4436' to '1.4437', you can say that is has gained a full basis point, or 1 pip.

 

Contrast this with the USD/JPY pair, which is only quoted to 2 decimal places. In this case, a move from 113.27 to 113.26 represents 1 pip at a value of .01.

 

Before you get too confused...

 

You should know that there is only one reliable source for quotes: Your Broker. The examples used in this report so far are just that: examples.

 

I've shown you EUR/USD pairs with more than 4 decimals places in the quote - and I've shown you a USD/JPY pair with more than 2 decimals in the quote.

 

Do not let this confuse you.

 

The fact is that you can get quotes online from a variety of public sources, but these quotes do not reflect the true buy/sell rates.

 

Instead, they represent what is known as 'mid-market rates'.

Mid-market rates are calculated by finding the average between buy and sell rates on highvolume transactions throughout the entire market. Further, every broker has its own set of fees or overhead charges per transaction, and these fees are included in the quotes they provide.

So, when you look at the mid-market rate, what you're looking at is an average, not an exact quote. This is why the number of decimal points appears to vary.

Once you have your own account with a reputable broker, though, you'll receive accurate quotes which follow the 'rules' regarding how many decimal points out a quote should go on a given currency pair.

A Typical Pip Value Calculation

 

The EUR/USD pair has a fixed value of U.S. $10 for Standard Lots, or 100,000 units of base currency. Similarly, a 'Mini' Lot transaction of EUR/USD has a fixed value of U.S. $1.

 

In order to calculate the actual pip value of the base currency within the pair, you must divide 1 pip by the current exchange rate, and then multiply the result by lot size:

 

EUR/USD = 0.0001 (1 pip) / 1.30000 (exchange rate) = EUR 0.0000769 x 100,000 (standard lot) = EUR 7.69

 

Next, we want to get our result into the base currency of our account. If your account uses U.S. Dollars for the base currency, you would multiply again by the exchange rate:
¹⁵ 7.69 x 1.30000 = $10.00 pip value

 

What Do Pip Values Tell Me?

 

Pips are used by Forex traders to calculate profit and loss. Recall, again, that pips represent the smallest increment changes in price of one currency relative to another.

In our EUR/USD example, a change in value of 1 pip means a potential profit or loss of U.S. $10. Whether you earn $10 or lose $10 depends on the value of the Euro relative to the Dollar (or vice versa).

Right now, the Euro is stronger - so, any downward change in the Euro would actually create a profit for you in U.S. Dollars. You would profit from 'buying high' and 'selling low', as counterintuitive as that sounds.

The reason Forex traders use pips to calculate profit and loss is because it simplifies the trade - or, I should say - because standard lot sizes simplify trades.

 

Pips calculations reflect the fact that almost all Forex transactions are undertaken in some multiple of 10.

 

We trade in lot sizes of 100,000, 10,000 and 1,000 so that the effects of even the slightest change in currency values can be seen right away, and capitalized on immediately.

 

The good news that you don't have to calculate these values yourself. Your broker will do it for you, and the information will be available in your online account.

 

It is crucial that you understand pips values on the conceptual level, even if you don't want to do the math yourself.
Concept #4 - Anatomy of a Trade: Bid Price; Ask Price and 'Spread'

 

Forex quotes include more than just the exchange rate. They also include a bid price and an ask price. Where do these prices come from?

 

They come from entities known as forex market makers. These market makers consist of banks and brokerages that are ready to buy and sell currency at a moment's notice.

 

If these market makers didn't exist, you would not be able to buy or sell currency at will. There has to be someone else involved in the transaction.

 

It is the market maker who sets the ask price for the currency being sold. The ask price is always higher than the bid price, which is typically equivalent to the exchange rate.

¹⁶ So, let's say that you want to buy Canadian Dollars. The market maker must purchase your U.S. Dollars with Canadian Dollars, so the transaction will first be expressed in terms of the exchange rate for the currency pair:

CAD/USD = 1.2

 

It will cost the market maker $1.20 CAD to purchase $1.00 USD from you. Good so far, right? Now, let's say you intend to sell $100 USD.

 

The bid price, then, is $120 CAD for $100 USD.

 

However, the market maker can choose to quote a higher price for his base currency. He can, for example, quote you an ask price of $100.05 USD for $120 CAD.

On your end of the transaction, though, you will see this mark-up expressed in CAD as an ask price of $120.05. In doing so, the market maker profits by requiring you to buy a fraction more Canadian Dollars. This is done so that he receives a fraction more in U.S. Dollars.

120.05 - 120.00 = 0.05 or $0.0005

 

This number represents what's known as the spread.

The concept of the “spread” is important when determining your profit and loss because you may be subject to it both when entering and exiting a trade. The amount of the spread will vary based on whether you are the buyer or the seller.

In the CAD/USD example, you entered the trade as a buyer. The fact that you are technically 'selling' U.S. Dollars in exchange for the Canadian Dollars does not matter here because the trade began with you responding as a buyer to a market maker's ask price.

If you wanted to enter a trade as a seller, then you would need to respond to a bid price for currency that you already hold.

 

The general rule of thumb is this:

 

ü As a buyer, you pay the spread as you enter a trade, but not when you exit. ü As a seller, you do not pay the spread as you enter a trade, but you do pay it when you exit as a buyer.

At this point, you might be thinking to yourself: “It looks like I get hit with a spread no matter what I do, because I'll inevitably be in the role 'buyer' at some point on every trade.” This is true, but your profit and loss depends partly on what kind of spread you're subject to during the transaction.

17

 

In our CAD/USD example, where you are a buyer, you are subject to the following spread on a trade of 100,000 units:

(.0001/1.2) x 100,000 = $8.33 x 5 pips = $41.65 If you close the trade as a seller at CAD/USD = 1.25 (bid price)/1.27 (ask price), you are not subject to the new spread of $0.0007 (7 pips). You simply close the trade with a sale, and subtract the spread from your profit.

However, let's say that you already had some Canadian Dollars, and decided to enter the trade as a seller at 1.27, and then close the trade as a buyer?

 

You would be subject to the new spread of 7 pips, or $56.

This means you have a potential gain or loss of $14.35 per lot, depending on when you enter the trade, and whether you have entered as a buyer or seller. It may not seem like much, but these types of losses and gains accrue with each trade.

As a retail trader, your margins will be small to begin with, and you can't afford to be careless.

Speaking of margins, you may wonder how you can get involved with Forex when the average lot size is $100,000. That is a very good question, and it leads into the concept of margins and leverage.

Concept #5: Margins and Leverage

 

Every broker will have a minimum deposit you must meet in order to open an account, as well as minimum account levels required to trade a specific lot size.

The minimums are known as initial margins or usable margins. Some brokers might allow you to open an account at lowest 'usable margin' possible, while others may require more as assurance against you falling below the minimum too rapidly.

The good news is that retail brokers typically do not require matching deposits. In other words, you need not deposit $100,000 in order to trade $100,000.

Instead, your broker will usually 'front' you the money on good faith. For instance, if you're broker requires you to trade in lot sizes of $100,000, you may be able to open an account for $1,000.

It is somewhat like getting a loan you don't have to repay because you get to “play” with $100,000 that isn't really in your account.

 

So, let's say you do really well and manage to trade your way from $100,000 to $105, 000:

 

₁₈ $105,000 - $100,000 = $5,000

You've now raised your real account balance to $6,000 and your usable margin by a factor of six. Remember, if your broker is matching you $100,000 for every $1,000 in your account, then your $6,000 account balance gives you $600,000 worth of leverage for trading on the market.

What happens if you fall below margin?

Let's say that your account balance falls below $1,000. Your broker can no longer match you with $100,000, and this means you have no usable margin, as the minimum to hold one open position on the market IS $100,000.

Neither you nor your broker will benefit from your account balance going negative, but it will do so if you don't have enough usable margins to hold your position.

 

Should you fall below margin, there are only 2 options:

 

1) You deposit more money into your account, or...

 

2) Your broker is forced to issue a margin call.

When your broker issues a margin call, he will close all of your open positions - in other words - he will cancel pending 'buys' and complete pending 'sales' to minimize loss, and insure that you do not lose your opening deposit.

Policies on margin calls vary from broker to broker, and you should familiarize yourself with your broker's policies prior to opening an account.

 

Some brokers will describe their policies in terms of leverage ratio, while others prefer to use margin percentage.

 

These requirements can be expressed mathematically as:

Leverage = 100/Margin Percent or
Margin Percent = 100/Leverage

Also, keep in m