Forex Basics

The following is an introduction to some basic terms, definitions and concepts used in forex trading.

Introduction

Foreign Exchange

The simultaneous transaction of one currency for another.

Foreign Exchange Market

An informal network of trading relationships between the world's major banks and other market participants, sometimes referred to as the 'interbank market'. The foreign exchange market has no central clearing house or exchange and is considered an over-the-counter (OTC) market.

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 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.

• How to calculate rollover interest
• Rollovers in Forex

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

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 runs a dealing desk and provides liquidity for a particular currency pair by standing ready to buy or sell that instrument by displaying a bid and offer price. Market makers earn their commission from the spread between the bid and the offer price.

Forex ECN Broker

ECN stands for Electronic Communications Network. A Forex ECN does not operate a dealing desk, but instead provides a marketplace where multiple market makers, banks and traders can enter competing bids and offers into the platform either inside or outside the spread, resulting in tighter spreads and allowing traders to trade on those prices. Orders are routed to the best available bid/offer price for a fee or commission.

Dealing Desk

A dealing desk is where all trades are executed and where prices originate from.

NDD

No Dealing Desk broker. A no dealing desk broker acts as an agent, matching up orders to one or more liquidity providers connected to their platform.

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.

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 fixed or variable depending on the currency pair and base currency of your account. e.g. The pip value for EURUSD is always $10 for standard lots and $1 for mini-lots. To calculate the pip value, divide 1 pip by the exchange rate and multiply it by the unit lot size to get the base currency pip value. To convert this back to your account currency, multiply it by the appropriate exchange rate. e.g. EURUSD = 0.0001 / 1.30000 * 100,000 = 7.69 Euro * 1.30000 = $10.00 pip value (fixed). USDJPY = 0.01 / 120.00 * 100,000 = $8.33 pip value (variable)

Lot

The standard unit size of a transaction. Typically, one "standard" lot is equal to 100,000 units of the base currency, or 10,000 units if it's a "mini" lot, and even 1,000 units if it's a "micro" lot. Some dealers offer the ability to trade in any unit size, down to as little as 1 unit!

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.

Standard Account

Trading with standard lot sizes

Mini Account

Trading with mini lot sizes

Margin

The deposit required to open or maintain a position. A 1% margin requirement allows you to control a $100,000 position with a $1,000 margin deposit.

Leverage

The extent to which you are using borrowed funds to gear your account. Increasing your leverage magnifies both gains and losses. To calculate leverage used, divide total open positions by account equity to get the leverage ratio. e.g. If a trader has $1,000 in his account and opens a $100,000 position, he is leveraging his account by 100 times, i.e. 100:1 leverage. If he opens a $200,000 position with $1,000 in his account, he is leveraging his account by 200 times, i.e. 200:1 leverage.

Manual Execution

An order which is executed by dealer intervention.

Automatic Execution

The order is executed by computer software without human intervention or involvement.

Slippage

The difference between the order price and the executed price.

Drawdown

The extent to which equity is lost in a trading account from a trade or series of trades, measured from peak to subsequent trough, most commonly in percentage terms.

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 that underpin the value of a currency.

Support

Support is a technical level where buyers outnumber sellers, causing prices to bounce off a temporary price floor.

Resistance

Resistance is a technical level where sellers outnumber 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 specified price level.

Stop-Loss Order

An order to restrict losses at a specified price level.

Limit Entry Order

An order to buy below the market or sell above the market at a 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 specified level, believing that the price will continue in the same direction.

Common Trade Types

Long

A position in which the trader profits from an increase in price. Buy low, sell high.

Short

A position in which the trader profits from a decrease in price. Sell high, buy low.

Carry Trade

A position whereby the trader attempts to profit from holding a currency with a higher interest rate and shorting a currency with a lower interest rate.

Common Trading Styles

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 technical levels of support and selling technical levels of resistance. The upper level of resistance and lower level of support defines the range.

News Trading

A style of trading whereby a trader attempts to profit from fundamental news announcements that may affect the price of a currency, usually immediately after the announcement is released.

Scalping

A style of trading that involves frequent trading seeking small gains over a very 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.

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 involves the human decision making process for every trade.

Automated Trading

A style of trading that involves neither human decision making or involvement, but uses a pre-programmed strategy that automatically executes trades via trading software.

Example Transaction

Assume you have a trading account of $25,000 and you are trading with a 1% margin requirement. The current quote for EUR/USD is 1.3225/28 and you place a market order to buy 1 standard lot of 100,000 Euros at 1.3228, expecting the euro to strengthen against the U.S. dollar. At the same time you place a take profit order at 1.3278, 50 pips above your order price.

The notional value of this transaction is $132,280 (100,000 units * $1.3228). Your required margin deposit is 1% of the total, which means you need $1322.80 in account equity to open this trade.

As you expected, the Euro strengthens against the U.S. dollar and your take profit order is reached at 1.3278. Your total profit for this trade is $500 (each pip being worth $10) for a total return of 38% on this trade.