As in any worthwhile endeavor, each industry tends to create its own unique lingo. The FOREX market is no different. You, the novice trader, must thoroughly comprehend certain terms before making your first trade.
Every FOREX trade involves the simultaneous buying of one currency and the selling of another currency. These two currencies are always referred to as the currency pair in a trade.
Major and Minor Currencies
The seven most frequently traded currencies (USD, EUR, JPY, GBP, CHE, CAD, and AUD) are called the major currencies. All other currencies are referred to as minor currencies. The most frequently traded minors are the New Zealand dollar (ND), the South African rand (ZAR), and the Singapore dollar (SGD). After that, the frequency is difficult to ascertain because of perpetually changing trade agreements in the international arena.
A cross currency is any pair in which neither currency is the U.S. dollar. These pairs may exhibit erratic price behavior since the trader has, in effect, initiated two USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. The three most frequently traded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY.
The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215. In the FOREX markets, the U.S. dollar is normally considered the "base" currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The primary exceptions to this rule are the British pound, the Euro, and the Australian dollar.
The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency.
A pip is the smallest unit of price for any foreign currency. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit that is, EUR/USD equals 1.2812. In this instance, a single pip equals the smallest change in the fourth decimal place, that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equals 1/100 of a cent.
One notable exception is the USD/JPY pair where a pip equals $ 0.01 (one U.S. dollar equals approximately 107,19 Japanese yen). Pips are sometimes called points.
Just as a pip is the smallest price movement (the y-axis), a tick is the smallest interval of time (the x-axis) that occurs between two trades. When trading the most active currency pairs (such as EUR/USD or USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second.
When trading a low-activity minor cross pair (such as the Mexican peso and the Singapore dollar), a tick may only occur once every two or three hours. Ticks, therefore, do not occur at uniform intervals of time. Fortunately, most historical data vendors will "group' sequences of streaming data and calculate the open, high, low, and close over regular time intervals (1-minute, 5-minute, 30-minute, 1-hour, daily, and so forth.).
When an investor opens a new margin account with a FOREX broker, he or she must deposit a minimum amount of monies with that broker. This minimum varies from broker to broker and can be as low as $100.00 to as high as $100,000.00. Each time the trader executes a new trade, a certain percentage of the account balance in the margin account will be earmarked as the initial margin requirement for the new trade based upon the underlying currency pair, its current price, and the number of units traded, (called a lot). The lot size always refers to the base currency. An even lot is usually a quantity of 100,000 units, but most brokers permit investors to trade in odd lots (fractions of
Leverage is the ratio of the amount used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a security with a comparatively small amount of capital. Leveraging varies dramatically with different brokers, ranging from 10:1 to 100:1. Leverage is frequently referred to as gearing. The formula for calculating leverage is: Leverage = 100/ Margin Percent
The bid is the price at which the market is prepared to buy a specific currency pair in the FOREX market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation. For example, in the quote USD/CHF 1.4527/32, the bid price is 1.4527; meaning you can sell one U.S. dollar for 1.4527 Swiss francs.
The ask is the price at which the market is prepared to sell a specific currency pair in the FOREX market. At this price, the trader can buy the base currency. It is shown on the right side of the quotation. For example, in the quote USD/CHF 1.4527/32, the ask price is 1.4532; meaning you can buy one U.S. dollar for 1.4532 Swiss francs. The ask price is also called the offer price.
The spread is the difference between the bid and ask price. The "big figure quote" is the dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be 117.30/117.35, but would be quoted verbally without the first three digits as "30/35."
Exchange rates in the FOREX market are expressed using the following format: Base Currency / Quote Currency Bid/Ask. Normally only the final two digits of the bid price are shown. If the ask price is more than 100 pips above the bid price, then three digits will be displayed to the right of the slash mark (that is, EUR/CZK 32.5420/780). This only occurs when the quote currency is a very weak monetary unit.
The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. The formula for calculating the transaction cost is: Transaction Cost = Ask Price - Bid Price
Rollover is the process whereby the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies.
Putting It All Together
Trading currencies on margin lets you increase your buying power. If you have $2,000 cash in a margin account that allows 100:1 leverage, you could purchase $200.000 worth of currency because you only have to post one percent of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power. With more buying power, you can increase your total return on investment with less cash outlay. To be sure, trading on margin magnifies your profits and your losses.
The Trader's Nemesis
All traders fear the dreaded margin call. This occurs when the broker notifies the trader that his or her margin deposits have fallen below the required minimum level because an open position has moved against the trader. Trading on margin can be a profitable investment strategy, but it is important that you take the time to understand the risks. You should make sure you fully understand how your margin account works. Be sure to read the margin
agreement between you and your clearing firm. Talk to your account representative if you have any questions.
The positions in your account could be partially or totally liquidated should the available margin in your account fall below a predetermined threshold. You may not receive a margin call before your positions are liquidated.
Margin calls can be effectively avoided by monitoring your account balance on a very regular basis and by utilizing stop-loss orders on every open position to limit risk. For ease of use, most online trading platforms automatically calculate the profit and loss of a trader's open positions.
Nearly all FOREX brokers monitor your account balance continuously. If your balance falls below four percent of the open margin requirement, they will issue the first margin call warning, usually by an online pop-up message on the screen and/or an email notification. If your account balance drops below three percent of the margin requirement for your open positions, they will issue a second margin warning. At two percent, they will liquidate all your open trades and notify you of your current account balance. These percentages may vary from broker to broker.