Forex terminology and concepts

In this post we will examine some of the terminology used in the Forex market. Some of it is not unique and is identical to the stock market. I will start with the Forex specific terminology.

Every Forex transaction involves the buying of one currency and the selling of another currency. The two currencies are known as the currency pair in the trade. The seven most frequently traded currencies are called the major currencies or major pairs. They are
  • US Dollar (USD)
  • Euro (EUR)
  • Japanese Yen (JPY)
  • Great British Pound (GBP)
  • Confoederatio Helvetica Franc (CHF) or know as Swiss Frank
  • Canadian Dollar (CAD) also known as the Looney.
  • Australian Dollar (AUD)

A cross-currency is any pair in which neither currency is the US dollar.  A cross currency trade initiates two USD trades. For example initiating a long (buy) EUR/GBP involves buying a EUR/USD currency pair and selling a GPB/USD pair.An exotic is a currency pair in which one currency is a major and the other a currency from a smaller country.

The base currency is the first currency in any currency pair. It shows how much the base currency is worth measured in the second currency.  If the USD/CHF rate equals 1.0120  then one US dollar equals CHF 1.0120.  The quote currency is the second currency in any currency pair.  This is frequently called the pip currency and any unrealised profit or loss is shown in this currency.

A pip is the smallest unit of price for any foreign currency. Most currency pairs consist of five digits and a decimal point immediately after the first digit.  An example is USD/CHF equals 1.0125. In this case a pip equals the the fourth decimal place  ie: 0.0005.  Therefore, if the quote currency in any pair is USD then one pip always equals 1/100  of a cent.  One important exception is the USD/JPY major pair where a pip equals $0.01.

When a person opens an account with a FOREX broker, he must deposit a minimum amount of money with that broker. This minimum is different from broker to broker and can be as low as $100 to as high as $100,000. Each time the trader executes a new trade, a certain percentage of the account balance in the account will be earmarked as the initial margin requirement for the new trade based on 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. A mini-lot is 10,000 units and a standard lot is 100,000 units.

The bid price is the price at which the market is willing to buy a specific currency pair. At this price the trader can sell the base currency. It is shown on the left side of the quotation. For example, in the the quote USD/CHF  1.0142/1.0143, the bid price is 1.0142 meaning you can sell one U.S dollar for 1.0142. The  ask price is the price at which the market is prepared to sell a Forex pair in the currency market. At this price the trader can buy the base currency. It is shown on the right side of the quotation. In the quote USD/CHF 1.0142/1.0143 , the ask price is 1.0143, so you can buy one USD dollar for 1.0143 Franks.

The bid-ask spread is the difference between the bid and ask prices. Different brokers and currencies have varying bid-ask spreads. It is important to have a broker that has a low spread. This is because the spread does reduce the amount of profit you can make and while it is mostly small amounts, be careful of large bid-ask spreads on the lesser known pairs. The bid-ask spread can be seen as the transaction cost of your trade.

A correlation in Forex refers to how one currency reacts relative to a price move in another currency. If two currencies move in the same direction ie: One goes up and the other goes up then the currencies have a high positive correlation. If two currencies move in opposite directions they are said to have a negative correlation. If you have two negatively correlated open at the same time then you are trading against yourself because the pairs will move against each other, countering any profits that can be made. If you have more than three pairs open at a given time then your portfolio is not efficient.

A market order is an order to buy or sell at the current price. This may be to start a new position or close a previous position. A market order may not take place at the current price because of the speed at which the Forex market moves. A Limit Order specifies a particular price to execute the order. If the price is touched then your order becomes a market order. With a limit order a trader attempts to receive a better price than the current market price, lower if you are buying and higher if you are selling. A trader must keep track of all their open orders because you could get a nasty surprise when a trade that you entered gets executed 3 weeks after you put it in. Review your open orders everyday so that you don’t get surprised. A Stop Order is the opposite of a limit order. It too specifies a particular price to execute the order but a trader tries to get a worse price than the current market price, higher if you are buying and lower if you are selling. You can also use a stop order to contain the amount of risk and loss for any trade. This is called a stop-loss order.

Another important concept is that of long and short. A trader is said to have gone long when he opens a trade by placing a buy order and expects the price to go up. A trader is said to have gone short when he opens a trade by placing a sell order with the expectancy that the price will go down.

This article provided some of the basic terminology used in the Forex market. There is much more of the language to learn but this will give a good foundation and enable the beginning trader to start understanding news articles and more advanced books on Forex trading. Much of this language will be difficult to grasp initially but as with anything new it must be practiced and applied until the concepts really sink in.      

Forex terminology and concepts

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