Forex Basics

By Tiri Chiweshe

In this article I will be describing the basic terms and simple calculations you will need to understand before we go deeper into forex trading. The stuff you will know at the end of this post is; the structure of a currency quote, some forex lingo used in naming some of the major currencies, margin and leverage, what a pip is and calculating profit and loss using pips and also types of orders in the FX market. Let’s begin…

If you watch any of the major financial news broadcasters like CNBC or Bloomberg you most likely have seen a currency quote. A quote in forex is basically the price at which one currency is trading relative to another at a moment in time. For example, we say the GBP/USD is trading at 1.5070/1.5072 with the normal convention being 1.5070/72 were we remove the first 3 numbers in the second price. The price on the left is the bid and the price on the right is called the ask or offer. The bid is the price at which you can sell the base currency (which I will discuss in a moment) and the ask/offer is the price at which you can buy the base currency {NB: the bid is always lower than the ask}. In this case our base currency is the GBP (British Pound). The base currency is the currency you’re buying or selling when you’re trading the pair.

The second currency in the pair, in this case the USD (United States Dollar), is called the counter or secondary currency, it is the denomination of the price fluctuations and ultimately what your profit and losses will be denominated in. If for example the pair moves to 1.5080/82 and you close the trade in which you’ll have bought this pair you get US$1.5080. Note that the quote in our example means that 1 British Pound is equal to 1.5070 US Dollars. In trading lets say you buy 100 000 GBP/USD, you will have bought 100 000 British Pounds and sold an equivalent amount of US Dollars. The opposite is true if you sell 100 000 GBP/USD. The difference you see between the bid and the ask is called the spread. This is what a forex broker earns when you make trades through his trading platform and these spreads differ from broker to broker and from one currency pair to another depending on their liquidity.

In the Forex market you can either be long or short any of the currency pairs you are trading. When you’re long it simply means that you’ve bought the base currency in which case you’ve concurrently sold the counter currency and when you’re short it means you’ve sold the base currency thus buying the counter currency. Like from other markets being long means that you have a bullish outlook and you are expecting the pair to go up and when you’re short it means you will profit if the pair goes down, meaning the base currency loses value, this being a bearish perspective. This brings us to the issue of lot sizes. A lot is the amount of currency you will be controlling in the market. 2 types generally exist and these are the 100 000 unit, called the regular lot, and the 10 000 unit called the mini-lot and another one called the micro lot, 1 000 units.

In a regular account, the average minimum deposit you will need for trading with leverage is 1 percent (i.e. 100:1 leverage), which means when you are trading in US dollars, $1 000 in your account will control a position of $100 000 in the market. For a mini-lot $100 will control $10 000 in the market. Margin is basically the amount in your trading account, collateral you might say, for the leveraged amount you will be controlling in the market, i.e. your margin (e.g. $1000) multiplied by a factor (100 representing leverage of 100:1) thus controlling 1 regular lot size of $100 000. I described the lot sizes generically as units because the specific currency which a unit will represent depends on the currency being traded. For example if a standard(regular) lot GBP/USD is traded, it would be 100 000 British Pounds and if it’s a USD/CHF (CHF=Swiss Franc) lot it would be 100 000 US dollars.

I mentioned pips in the introductory paragraph and you might be wondering what the hell they are. Well, colloquially these are the currency in currency trading. PIP can stand for “percentage in point” or “price interest point.” A pip is the smallest increment in price fluctuation in currency prices, the last digit in a quote. If for example in the GBP/USD pair the price was to move from 1.5050 to 1.5059 we would it has moved by 9 pips and if it were to move again to 1.5069 we would say it has moved by 10 pips. When you’re trading, you trade to earn pips and if you lose in a trade you lose pips. They are your reward and punishment.

Now that we know what a lot is, what a pip is and what a currency pair is, lets move on to how we will calculate our profit and losses. In trading forex, like I mentioned earlier, your profit or loss will be in pips. The next step after this would be to know the value of a pip in a single trade that you make and this you can easily calculate using this equation: Value Per Pip= [Lot Size] X [Number Of Lots] X [Pip Size]. The value coming from this calculation will be denominated in the counter currency (the second currency in the pair, it can also be called the quote currency) and if you are valuing your trading account in US dollars you will then need to convert that value into US dollars using the prevailing exchange rate of the US dollar against that currency. But if the quote currency is the US dollar there will be no need for this. Lets use a few examples to clear this up: 1) Pip value for 1 standard lot of the EUR/USD pair Value Per Pip= 100 000 X 1 X 0.0001 (pip size is the last digit in a quote, the currency pair has 4 decimal places) = $10 2) Pip value for 1 standard lot of the USD/JPY pair Value Per Pip= 100 000 X 1 X 000.01 (USD/JPY is 101.01) = 1000 yen Yen to USD = 1000/101.01 = $9.9

The good news is that you don’t have to calculate the profit you are making continuously in real time because the online FX trading platforms offered by brokers do this for you automatically. So why the hell do we need to know this? Because online trading platforms only calculate your profit and loss after you enter a trade but to structure a trade and plan a risk management strategy(stay tuned) you might need to know the value of your pips beforehand. And knowing the basics of how these values are calculated is essential anyway. NB: While the lot size, amount of lots traded and specific currency pair will affect the value of a pip, the leverage chosen by the trader, whether it is 50:1 or 400:1, has no direct bearing whatsoever on pip value but instead indirectly by increasing the number of lots you can trade with lesser margin.

I was going to write more on types of orders, some of the colloquial terms used to describe some of the pairs and interest rates, well my fingers are sort of numb and I’m guessing you must be tired of reading too so why don’t we leave this for tomorrow (Visit my blog at http://www.thforex.co.cc)…. Right?

Tiri

(Visit my blog at http://www.thforex.co.cc )

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