Lesson 5: Forex Terminology You Need to Know
Forex has its own language, that is, special terminology. If you don’t want to be embarrassed in front of other traders, it’s useful to know that a pip is not a seed in an orange, and execution is not about playing Russian roulette.
It is the quotation of one currency unit against another currency unit.For example, the euro and the US dollar together make up the currency pair EUR/USD. The first currency (in our case, the euro) is the base currency, and the second (the US dollar) is the quote currency. As you see, we use short forms for currencies: euro is EUR, US dollar is USD, and Japanese yen is JPY.
It is the rate at which you exchange one currency for another. The exchange rate shows you how much of the quote currency you need if you want to buy 1 unit of the base currency.
Example: EUR/USD = 1.3115. This means that 1 euro (the base currency) is equal to 1.3115 US dollars (the quote currency).
Now take a quick peek at how the euro is doing against the Japanese yen: for 1 euro I can get 106.53 Japanese yen (i.e. EUR/JPY=106.53). Maybe I’ll wait until the euro gets stronger before I exchange it and fly to Tokyo again.
The exchange rate may change in 2 days or 1 week, though. It may even stabilize for a while. Okay, but when? If you’re a time freak like me, the when is important to you, too.
The when is a question that nobody can answer precisely. It depends on a great deal of social and economic factors, many of which you’ll be watching more closely when you start trading forex.
Why? Because currency rates change all the time, and you want to know when to buy one currency and when to sell another to make a profitable deal.
It is a market price that always consists of 2 figures: the first figure is the bid/selling price, and the second is the ask/buying price. (e.g. 1.23458/1.12347).
Also known as the offer price, the ask price is the price visible on the right-hand side of a quote. This is the price at which you can buy the base currency. For example, if the quote on the EUR/USD currency pair is 1.1965/67, it means that you can buy 1 euro for 1.1967 US dollars.
It is the price at which you can sell a currency pair. For example, if the EUR/USD is quoted at 1.4568/1.4570, the first figure is the bid price at which you can sell the currency pair. Bid is always lower than ask. And the difference between bid and ask is the spread.
It is the difference in pips between the ask price and the bid price. The spread represents the brokerage service costs and replaces transaction fees. There are fixed spreads and variable spreads. Fixed spreads maintain the same number of pips between the ask and bid price, and are not affected by market changes. Variable spreads fluctuate (i.e. increase or decrease) according to the liquidity of the market.
It is the currency you choose when you open a trading account with XM. All your profits and losses will be converted into that particular currency. At XM you can open any kind of trading account you prefer with many base currency options: USD, EUR, GBP, JPY, CHF, AUD, HUF, PLN, or RUB.
So if you open an account in USD but you transfer funds in EUR, the funds will be automatically converted into USD at the prevailing inter-bank price.
What is a Pip?
A pip is the smallest price change of a given exchange rate. Are you a visual type? Here’s an example: if the currency pair EUR/USD moves from 1.2550 to 1.2551, that’s a 1 pip movement; or a move from 1.2550 to 1.2555 is a 5 pip movement. As you see, the pip is the last decimal point.
All currency pairs have 4 decimal points – the Japanese yen is the odd one out. Pairs that include JPY only have 2 decimal points (e.g. USD/JPY=86.51).
It is an extra decimal place in the exchange rate. In the case of non-JPY pairs, we have 1.23456 instead of 1.2345, while in pairs that contain JPY, we have 123.456 instead of 123.45. We call the last decimal place in such pricing a pip fraction or tenth pip.
Forex is traded in amounts called lots. One standard lot> has 100,000 units of the base currency, while a micro lot has 1,000 units. For example, if you buy 1 standard lot of EUR/USD at 1.3125, you buy 100,000 Euros and you sell 131,250 US dollars. Similarly, when you sell 1 micro lot of EUR/USD at 1.3120, you sell 1,000 Euros and you buy 1,312. US dollars.
The pip value shows how much 1 pip is worth. The pip value changes in parallel with market movements. So, it is good to keep an eye on the currency pair(s) you are trading and how the market changes.
Now let’s reflect on what you have learnt about pips! To benefit from pips and see significant a increase/decrease in profit, you will need to trade larger amounts. Suppose your account currency is USD and you choose to trade 1 standard lot of USD/JPY. How much is 1 pip worth per $100,000 on the USD/JPY currency pair?
The calculation formula is as follows:
Amount x 1 pip = 100,000 x 0.01 JPY = JPY 1,000 If USD/JPY = 130.46, then JPY 1,000 = USD 1,000/130.46 = USD 7.7 Therefore, the value of 1 pip in USDJPY is equal to: (1 pip, with proper decimal placement x amount/exchange rate)
Here is another example:
In the EUR/USD pair, a movement from 1.3151 to 1.3152 is 1 pip, so 1 pip is .0001 USD. How much US dollar is this movement worth per $1,000 micro lot? 1,000 x 0.0001 USD = 1 USD.
Margin is the minimum amount of funds, expressed as a percentage, that you will need if you want to open a position and keep your positions open.
If you trade on a 1% margin, for instance, for every USD 100 that you trade, you need to put down a deposit of USD 1. And so, in order to buy 1 standard lot (i.e. 100,000 of USD/CHF), you need to maintain only 1% of the traded amount in your account i.e. USD 1,000. But how can you buy 100,000 USD/JPY with only USD 1,000? Basically, margin trading involves a loan from the forex broker to the trader.
When you carry out a forex transaction, you don’t actually buy all the currency and deposit it into your trading account. Practically speaking, what you do is speculate on the exchange rate. In other words, you estimate how the exchange rate will move, and you make a contract-based agreement with your broker that he will pay you, or you will pay him, depending on whether your estimation has proved to be correct or wrong (i.e. whether the exchange rate has moved in your favor or against your initial speculation).
If you purchase a USD/JPY standard lot, you don’t need to put down 100,000 USD as the full value of your trade. Instead, you will have to put down a deposit that we call margin. This is why margin trading is trading with borrowed capital. In other words, you can trade with a loan from your broker, and that loan amount depends on the amount you initially deposited. Margin trading has another big advantage: it allows leverage.
As you can see in our example, your initial deposit serves as a guarantee for the leveraged amount of 100,000 USD. This mechanism ensures the broker against any potential losses. Moreover, you as a trader are not using the deposit as payment, or to purchase currency units. Your broker needs a so-called good-faith deposit from you.
Strictly speaking, through leverage the forex broker lends you money so that you can trade bigger lots:
Leverage depends on the broker and its flexibility. At the same time, lLeverage varies: it can be 100:1, 200:1, or even 500:1. Remember that with leverage you can use $1,000 to trade $100,000 (1,000×100) or $200,000 (1,000×200), or $500,000 (1,000×500).
This sounds great, but how does it actually work? I open a trading account and I get a loan from my broker as simply as that?
Firstly, it depends on what type of account you open, what the leverage for that particular account type is, and how much leverage you need. Don’t be greedy – but don’t be too shy, either. Leverage can be used to maximize gains – but also losses, if you are too greedy. Secondly, your broker will need an initial margin on your account, that is, a minimum deposit.
How this Leverage works?
You open a trading account that has a leverage of 1:100. You want to trade a position worth $500,000 but you only have $5,000 in your account. No worries, your broker will lend you the remaining $495,000 and sets aside $5,000 as your good faith deposit.
The profits that you make by trading will be added to your account balance – or, if there are losses, they will be deducted. Leverage increases your buying power and can multiply both your gains and losses.
Always choose a broker that offers no negative balance protection, and so your losses will never exceed your capital. This means that if your loss reaches USD 5,000, your positions will be closed automatically so that you will not end up owing money to your broker.
It is the total amount of money in your trading account, including your profit and losses. For instance, if you deposited USD 1,000 in your account and you also made a profit of USD 3,000, your equity amounts to USD 13,000.
It is the amount of money kept aside by your broker so that your current trading positions can be kept open and you don’t end up with a negative balance.
It is the amount of money in your trading account with which you can open new trading positions.
Free margin = Equity – Used Margin.
This means that if your equity is USD 13,000 and your open positions require USD 2,000 margin (used margin), you are left with USD 11, 000 (free margin) available to open new positions.
Margin calls are a major part of risk management: as soon as your Equity drops to a percentage of the margin used, your forex broker will notify you that you need to deposit more money if you want to maintain your position. At XM this percentage is 50%.
Now that you’re not a complete beginner any more, let’s get down to calculating your profit (or loss).
We will take the USD/CHF currency pair. You want to buy USD and sell CHF. The quoted rate is 1.4525 / 1.4530.
Step 1: you buy 1 standard lot of 100,000 units at 1.4530 (ask price). Wait! In the meantime the price has moved to 1.4550, so you decide to close the position.
Step 2: you can see the new quote for your USD/CHF currency pair. It’s 1.4550 / 1.4555. You are already closing your position, but don’t forget that you initially bought a standard lot to enter the trade. Now you are selling in order to close your trade. You must take the bid price of 1.4550.
Step 3: you start calculating. What do you see? The difference between 1.4530 and 1.4550 is .0020. This equals 20 pips.
Do you remember our calculation formula earlier? You will be using it now.
100,000 x 0.0001 = CHF 10 per pip x 20 pips = CHF 200 or USD 137.46
Important! When you enter and exit your position, you must always watch the spread in the bid/ask quote. As you learnt it before, you use the ask price when you buy a currency, and the bid price when you sell a currency.
It is a trade that you hold open during a certain period of time.
When you enter a long position, you buy a base currency.
Supposing that you choose the EUR/USD pair. You expect the EUR to strengthen as compared to the USD, so you will buy EUR and profit from its increase in value.
When you enter a short position, you sell a base currency. If you choose the EUR/USD pair again, but this time you expect the EUR to weaken as compared to the USD, you will sell the EUR and profit from its decrease in value.
Close a Position
If you enter a long (buy) position and the base currency rate has gone up, you want to get your profit. To do so, you must close the position.
Market Order / Entry Order
It is an order to buy or sell currency instantly at the current price.
It is an order to buy/sell a financial instrument (e.g. forex, stocks, or commodities like oil, gold, silver, etc.) that will stay open until you close it, or you have your broker close it for you (e.g. via telephone trading).
It is an order placed away from the current market price.
Assuming that EUR/USD is traded at 1.34. You want to go short (place a sell order on this currency pair) if the price reaches 1.35, so you place an order for the price 1.35. This order is called limit order. So your order is placed when the price reaches the limit of 1.35. A buy limit order order is always set below the current price whereas a sell limit order is always set above the current price.
It is an order that you give to buy above the current price or an order to sell below the current price when you think the price will continue in the same direction. It is the opposite of a limit order.
Let’s assume that EUR/USD is traded at 1.34. You want to go long (i.e. place a buy order on this currency pair) if the price reaches 1.35, so you place a stop-entry order to buy at 1.35. This order is called stop-entry order.
Take Profit Order (TP)
It is an order that closes your trade as soon as it has reached a certain level of profit.
Stop-Loss Order (SL)
It is an order to close your trade as soon as it reaches a certain level of loss. With this strategy, you can minimize your loss and avoid losing all your capital.
You can make stop-loss orders with automated trading software. It’s a great thing because even if you’re on holiday when you don’t watch how the market and currency rates change, the software does it for you.
It is the process of completing an order.
When you place an order, it will be sent to your broker, who decides whether to fill it, reject it, or re-quote it. Once your order is filled, you will receive a confirmation from your broker. Unlike other forex brokers, XM operates with a strict No Rejections and No Re-quotes policy.
It is crucial to have your orders executed quickly. If there is a delay in filling your order, it can cause you losses. That is why your forex broker should be able to execute orders in less than 1 second. Why? Forex is a fast-moving market – and many Forex brokers don’t keep pace with its speed, or purposefully slow down execution to steal a few pips from you even during slow market movements.
Now you have taken your first steps and learned to toddle around in the world of Forex. And most importantly, you now know the basic Forex terminology. It’s time to open a demo account and start practicing with virtual money. However, before you do that you have to make two important decisions: you need to choose a broker and a trading platform.
In our last lesson of the beginner’s Forex trading course, you will learn how to select the best Forex broker for your needs.