Essentially, forex trading is buying one currency and selling another. Hopefully the currency you bought will raise in value and turn a profit for you. Here is an example below:
You purchase 10,000 euros at the EUR/USD exchange rate of 1.1800
Two weeks later, you exchange your 10,000 euros back into U.S. dollar at the exchange rate of 1.2500
You earn a profit of $700
*EUR 10,000 x 1.18 = US $11,800
** EUR 10,000 x 1.25 = US $12,500
The ratio of one currency valued against another is the exchange rate. USD/EUR shows how many euros someone can buy with the US dollar.
The first currency listed in a pair is called the base currency and is the basis. The second currency is called the counter currency or quote currency. In a currency pair, you would sell the pair if you believed the base currency will depreciate, and buy the pair if you thought the base currency will go up in value.
First you have to determine whether you want to buy or sell. In traders talk, “going long” means you want the base currency to go up in value so you can sell it back to turn a profit. Long = Buy.
When you want to sell, “going short” means you want the base currency to fall in value so you can buy it back at a lower price. Short = Sell.
All forex quotes are quoted with two prices. The bid is the price your broker is willing to buy the base currency in exchange for the quote currency. Essentially, the bid price is the best available price for the trader to sell to the market.
The ask price is the opposite and is the price at which your broker will sell you the base currency in exchange for the quote currency. The offer price is another way of saying the ask price.
The difference between the bid and ask prices is known as the spread.
Let’s look at the currency pair USD/JPY. The USD is the base currency, so if you believe the US economy will strengthen, then you would execute a buy USD/JPY. You would execute a sell USD/JPY if you think the US economy will weaken.
In forex, nobody buys or sells just 1 Euro. They come in “lots” of 1000 units of currency (micro), 10,000 units (mini), or 100,000 units (standard). This also depends on what broker you are using and the account type you have with your broker.
Not everybody has enough money to buy 10,000 USD. Margin trading allows people to trade with essentially borrowed capital. Large transactions can be conducted with little amount of initial capital. Here is an example below:
The profit or loss is credited to your account after you close a position. Some brokers even allow for custom lot sizes.
The trader pays or earns a daily rollover or interest rate for positions open at your broker's cut-off time (usually 5:00 pm EST). Interest is paid on the currency that is sold and earned on the currency which is bought.
If the interest rate is higher with the currency you are buying, then there will be a positive net interest rate differential. On the flip side, if there is a negative interest rate differential and you will have to pay.
Different brokers or dealers have different rules regarding rollover so check with them. Leverage and interbank lending rates can also be deciding factors. The benchmark interest rates for the major currencies are listed below.
Simply put, a pip is the unit of measurement that expresses the change in value between two currencies. If USD/EUR moves up from 1.2249 to 1.2250, that .0001 raise in value would be one pip. It is usually the last decimal place in a quotation. There is an exception with the Japanese yen pairs that only go out to two decimal places.
Currency pairs are quoted in some brokers beyond the “4 and 2” decimal places to “5 and 3” decimal places. These are called fractional pips or “pipettes.” For example, a one pipette movement would be 1.52456 to 1.52457.
Each currency in a pair has its own relative value, so it’s important to calculate the value of a pip to each currency in the pair.
Not every trader has their account denominated in the same currency since it is a global market. Finding the pip value in terms of your account currency is very important. So whatever currency your account is traded in, you have to find the pip value for that currency.
Forex brokers will do this math for you, but it’s good to know. There are also apps and other programs that offer pip value calculators!
|Lot||Number of Units|
To see a noticeable profit or loss in the forex world, large amounts of currency needs to be traded. Let’s use a 100,000 unit (standard) lot size to see how it affects some of the pip values.
The formula is a little different when the USD is not quoted first.
The pip value will move as the market moves depending on which currency you are trading. Don’t forget, your broker will help you determine the pip value.
Let’s use an example and pretend we are buying US dollars and selling Swiss francs.
Exiting the trade makes you the subject of the bid/offer quote. Use the ask price for buying currency and the bid price for selling currency.