Learning to trade Forex can seem daunting when the language being used seems as foreign as a Mongolian togrog.
One of the first steps on the road to trading Forex successfully is to get up to speed with the terminology. Here's an at-a-glance guide to key terms you need to know.
What is Forex?
Forex, or FX, stands for the foreign exchange market. Currencies are traded 24 hours a day. Everything from US Dollars for Euros, Japanese Yen for Sterling, Australian Dollars for Swiss Francs and the rest. If you have ever taken a foreign holiday you'll already be familiar with the process of course - by exchanging your own currency at the bank or the post office, or via Western Union, for the currency of the country you're visiting.
What marks it out from other forms of trading – stocks/indices/commodites – is the absence of a central, trading floor such as a stock exchange. Instead, trade is conducted over-the-counter via an international network of dealers. Most Forex is traded by the big banks in fact.
Who gets the commission in Forex trading?
The Forex market does not have commissions. Why? It's because unlike with trading stocks, futures or options, there is no broker. FX is a principals-only. Instead of brokers, Forex firms are dealers who assume market risk. Rather than making money from a commission, dealers make earn their crust through the bid-ask spread.
Basic Forex terms
Cross rate - The currency exchange rate between two currencies, neither of which is the official currency of the country in which the exchange rate quote is given in.
Example: if an exchange rate between the Swiss Franc and the US Dollar were quoted in the British Financial Times, it would be classed as a cross rate as neither the franc nor the dollar is the standard currency of the UK. If the FT quotes the exchange rate between the British Pound and the US Dollar, then we don't have a cross rate because the quote involves the official UK currency.
Be careful, however, as cross rate is occasionally used to refer to any currency quotes which do not involve the US dollar, regardless of which country the quote is being provided in. So even if you're sitting in Auckland and dealing only in New Zealand Dollars, you could still come over cross rate a lot.
Exchange rate – What it's all about really - the value of one currency expressed in terms of another. For example, if GBP/USD is 1.6500, £1 (British Pound) buys $1.65.
Pip – The smallest increment of price movement a currency can make. A pip is also often called a point. It's the smallest price change any given exchange rate can make. Most major currency pairs are priced to four decimal places, meaning the smallest change is that of the last decimal point.
For example, the smallest move the USD/CAD currency pair can make is $0.0001, or one point. It's not always the case that the smallest move is equal to one point, but it is generally the case with most currency pairs.
The exception is the Japanese yen. The quotation in the USD/JPY pair is only taken out to two decimal points , that is 1/100th of yen, as opposed to 1/1000th with other major currencies
Leverage - basically, leverage magnifies your gains and losses when trading Forex. It's defined as the ability to gear your account into a position greater than your total account margin, and is in effect a loan provided by the dealer.
In the Forex market, the leverage is among the highest achievable. You can trade $400,000 of currency with just $1,000 in your account, using leverage of 400:1. That's an extreme example of course, but it's a ratio that is actually offered by some brokers.
It seems incredibly risky, but bear in mind that currency prices fluctuate far less than equities for example. Intra-day fluctuations are usually less than 1%, allowing much greater leverage to be employed. But be very aware that it can be dangerous to use too much leverage!
So when the GBP/USD moves 100 pips from 1.9300 to 1.9400, it is actually just a one-cent move of the exchange. If you are trading $1,000, without leverage this would equate to just a $10 profit (or loss). In other words, you need leverage in order to trade in sensible amounts without already having pots in the bank.
Trade the same fluctuation with leverage of 100:1 and you can make $1,000. On the other hand, you lose the $1,000 as we have already said leverage will magnify losses as well as profits.
When trading Forex, you should select your real leverage amount based on your trading style, personality and how you like to manage your money. You should also never break one of the cast iron rules of Forex trading; never risk money you cannot afford to lose.
Margin – Margin is the deposit required to open or maintain a position/trade. There are two terms to know about. First we have 'used margin', which is the amount to maintain an open position. The other is 'free margin' which is the amount available to open new positions.
What you need to be aware of is a 'margin call', which occurs if your account falls below or gets close to the minimum amount required to maintain an open position. The broker simply protects himself and you by asking for more funds, or by using some more of the total you originally deposited with him.
Spread - The term 'spread' refers to the difference between the sell quote and the buy quote or the bid and offer price. It is sometimes called the bid/ask spread. Like the zero on the roulette wheel, it's a failsafe for the dealers to make their crust. To make money trading Forex, a position must move in the direction of the trade by an amount greater than the spread.
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