Forex trading can be overwhelming for beginners. Here’s a quick breakdown of basic forex definitions and terms for those new to FX trading.
What Is Forex?
Forex refers to the foreign exchange market, the largest financial market in the world. The world’s different currencies are bought, sold, and traded in the hopes that fluctuations in exchange rates will yield a profit for buyers and sellers.
Individuals or organizations licensed by the US Commodities Future Trading Commission (CFTC) to deal in futures products and to accept money from clients to trade them are called Futures Commission Merchants (FCM). FCMs are similar to securities brokers.
The Forex trading platform used by buyers and sellers is called the Electronic Communications Network (ECN). Like the ECN of the stock market, the Forex ECN makes it possible to trade, buy, and bid in real time from all over the world.
Exchange rate is determined by the value of one currency compared to that of another. An exchange rate will usually be represented by ISO currency codes written as currency pairs. Take a look at this example:
EUR and USD are the currency codes, where EUR stands for Euro and USD stands for US Dollar. Together they are the currency pair. The first currency in the pair is called the base currency, but this term can also refer to the currency your account is traded in. The second currency is called the counter currency. The exchange rate in the example is 1.3400. This means that 1 Euro is worth 1.34 US Dollars.
There are many ISO currency codes, but here are a few of the most commonly traded:
- AUD – Australian Dollar
- CAD – Canadian Dollar
- CHF – Swiss Franc
- EUR – Euro
- GBP – British Pound
- JPY – Japanese Yen
- NZD – New Zealand Dollar
- USD – US Dollar
Certain currency pairs are also more commonly traded than others. Many Forex brokers and traders use the following slang for these pairs:
- AUD/USD – “Aussie Dollar”
- EUR/USD – “Euro”
- GBP/USD – “Cable” or “Sterling”
- NZD/USD – “Kiwi”
- USD/CAD – “Dollar Canada”
- USD/CHF – “Swissy”
- USD/JPY – “Dollar Yen”
A pip is the most common increment of currencies. It is the smallest value change in the exchange rate of a currency pair and is usually found in the last decimal point. Positive or negative pip is how you calculate your profit or loss. For example, if your EUR/USD 1.3400 becomes EUR/USD 1.3401, then the exchange rate has increased one pip.
The value of the pip can be fixed or variable depending on the base currency of your account or the currency pair you’re trading. The EUR/USD pip value is always going to be $10 for standard lots and $1 for mini lots. In order to calculate the pip value of the currency you’re trading, divide one pip by the exchange rate and then multiply it by the lot size. Converting pip value to your currency value is simple as well; just multiply the pip value by your exchange rate.
The standard size per transaction is referred to as the lot. Typically, lot size is 100,000 units of base currency. A mini lot is only 10,000 units, and some Forex brokers will even let you trade in micro lots from 1,000 units all the way down to one unit. Having a mini or micro account requires less investment than a standard account.
The difference between the sell quote and the buy quote is known as the spread. Take a look at this example:
The difference in our spread is one pip. For Forex traders to break even, they must move their position in the direction of the trade. They must move equal to the amount of the spread.
Borrowing funds to gear your account is what’s known as leveraging. By increasing leverage, traders can either gain or lose more funds. In order to calculate leverage ratio, divide your total open positions by your account equity. If you have $1,000 in your account and open up a $100,000 position, you are leveraging by 100 times, or 100:1.
The deposit required to open or maintain a higher position is called the margin. In the above example, you have a 1% margin.
Nobody likes to lose, but if you do, the amount of equity lost in a series of trades is called the drawdown. Drawdown is a peak-to-trough measure usually expressed in a percentage. If you start with $10,000 and lose $2,500 one day and $2,500 the next, then your account would have $5,000 left; you would have a 50% drawdown. That’s not what you want in an FX trading transaction.