Forex Trading Basics (learn forex online)

A Brief Background

The forex market includes every currency denomination in the world since every nation imports and exports products. Generally, nations use their own currency to buy products from other countries. Whether it's a trader looking to profit by trading a foreign currency, an American restaurant buying French wine, a Swedish furniture maker buying bolts from South Korea, or a tourist on vacation, each needs to trade currencies for any transaction to occur. These practical uses for currency trading create a fluid market for the forex speculator. However, unlike other types of trading, forex is a fairly new phenomenon.

The forex market is relatively new, only forming in the 1970s when countries gradually shifted to floating exchange rates. Until the 1970's, and for the previous 100 years, the value of a currency was tied in some way to the value of gold. In 1944 the Gold Standard was abolished and replaced by the Bretton Woods Agreement which valued the United States Dollar against gold, and all other currencies against the US dollar. In 1975 that agreement fell apart and a system of floating exchange rates was widely adopted.

Despite formation of the forex market in the 1970s, access to the forex market by small speculators was very limited until the late 1990s, when widespread access to Internet technologies made market access practical. Today, individual speculators form a large part of the market, which had previously been accessible only by large commercial institutions.

What currencies are traded?

While all currencies are included in the forex market, the vast majority of trades (90%) include just 14 currencies, while just 4 currencies, the United States Dollar, the Euro, the Japanese Yen and the British Pound, are used in approximately 77% of all trades.

The currencies most traded, commonly abbreviated to the country name and the currency name, are the United States Dollar (USD), the Euro (EUR), the Japanese Yen (JPY), the Great Britain Pound (GBP), the Swiss Franc (CHF), the Canadian Dollar (CAD), the New Zealand Dollar (NZD), and the Australian Dollar (AUD).

Forex always involves two currencies: one currency being bought, in exchange for another currency. Together, the two currencies are called a currency pair. The most popular forex currency pairs traded are:

The order of the currencies in the pair is significant and important to understand. When buying a currency pair, the first currency of the pair (the base currency) is being purchased, and the second currency (the quote currency) is being sold.

As an example, if you buy EUR/USD you are actually buying Euros and selling US Dollars at the same time. You would profit if the Euro increased in value as compared with the US Dollar.

If you thought instead, that the Euro was likely to decrease in value, you would sell the EUR/USD. That trade would actually consist of a sale of Euros and purchase of US Dollars. Note that you could not simply buy the currency pair in the 'opposite' order. USD/EUR simply does not trade or is not offered on trading platforms.

Currency pairs therefore have a common or preferred order. As mentioned above, EUR/USD is the preferred order for that trade, and is offered on trading platforms. However, the pair USD/EUR is not offered or available to trade. This seeming arbitrary choice of order does not in any way restrict trading possibilities. The trader just needs to remember that he can buy or sell any pair at any time (i.e. a pair that is not owned can be sold, and the purchased later).

Trading Hours

With only a short break on the weekend, forex trading takes place 24 hrs per day. With the increased use of global high speed Internet connections and 24 hour trading, the forex market is an almost constant activity centre.

A Few Forex Terms

Everyone trading forex needs to know the basic terms listed below to get started. For more information, be sure to browse our online glossary.

Foreign Exchange

Foreign exchange, or Forex, is a decentralized global market for buying and selling currencies.

Spot Market, Forwards and Futures Markets

The "spot market" is the largest segment of the forex market, and deals with the current price of currency, and immediate trades. The "forwards market" involves custom designed contracts for independent transactions occurring at a specific future date. The "futures market" involves standard contracts for a future date, under the auspices of an established exchange.

Currency Pair

Two currencies are always involved in a forex trade - one is being bought in exchange for the other. Together, those two currencies are called a currency pair, and are usually represented as two three-letter currency abbreviations. For example, consider the currency pair EUR/USD. In this example, the first currency, the Euro (EUR), is called the Base Currency and the second, the US Dollar (USD) is called the Quote Currency.

For most transactions, either the USD or EUR is used as the base currency. In the case of the example EUR/USD, the value of the USD (the quote currency) is considered in relation to 1 EUR. If the quoted price for this pair is 1.3553, this means that 1 Euro can buy 1.3533 US Dollars.

Here is how that information might be used. If a trader thinks that the value of the US Dollar will decrease in value relative to the Euro, he might buy the EURUSD, currency pair and then later sell the pair for a profit when the value of the pair increases (representing a decrease in the value of the USD, the quote currency) See below for a detailed example of a similar trade.

Pip

A pip is the smallest unit of price for any currency. It is an abbreviation of Percentage in Point. Most currencies are expressed to the fourth decimal point, and the pip is the smallest change in the fourth decimal place, or 0.0001. This means that for USD, a pip is 1/100th of a cent. The Japanese Yen is the only currency expressed to the second decimal place, making its pip value 0.01. Profits or losses in forex trading are often expressed as pips.

Bid Price, Ask Price and Spread

Bid and Ask Price

In any forex transaction, one currency is sold at the same time another is bought. Just as in an auction, the foreign exchange market uses the terms Bid and Ask to describe the value of the currency.

A simple rule to remember when considering a forex trade is that you can buy a currency pair at the Ask price, and sell it at the Bid price. It is easy to remember which price is which: the market "Bids" a certain price when it buys a pair from the forex trader, and is "Asks" a certain price when it sells a currency pair to the trader.

The terms Bid and Ask make best sense when considered from the perspective of the Market. The Bid price is the price at which others are willing to purchase a particular currency pair, while the ask price is the price at which others are willing to sell the currency pair.

To restate this important concept in terms of base and quote currencies, the Bid price is the amount the market is offering to buy the base currency, while the Ask is the amount that the market is asking to sell the base currency (in a price denominated by the quote currency).

Forex prices sometimes express both Bid and Ask values in the form Bid/Ask. For example, a USD/CAD forex quote might be expressed as 1.0180/83. This price indicates that the Bid is 1.0180, and the Ask price is 1.0183.

Spread

Spread is the difference between the Bid and Ask prices. In the case of the USD/CAD forex quote mentioned 1.0180/83, the spread is .0003, often expressed as "3 pips". Forex brokerages often set the spread of currency pairs offered at fixed amounts. For the forex trader, this fixed spread allows for better pricing consistency from trade to trade.

For an example of how this information is used when calculating profit and loss in forex trading, please see the Mechanics of Forex Trading section.

Leverage and Margin

Leverage

Leverage allows a large amount of currency to be bought with a small investment. The amount of leverage available to a trader varies with the broker, for example 100:1, meaning that currency trades worth $100,000 can be made with an investment of $1,000. The word "leverage" originally meant the effect of using a lever to move a much larger object. In forex terms, leverage allows the use of credit to buy more currency with just a small amount of money on deposit. That deposit money is usually called "margin".

Margin

Margin refers to money actually deposited into a forex trading account. A trader must have a certain amount of money, the "margin" in their account before they can trade in the forex market. The amount required relates directly to the amount of leverage available. For example, if a margin account has a value of $1000 and leverage is 100:1, the trader can trade up to $100,000 in foreign currencies. Note that the amount of available margin will increase or decrease as the value of the forex currencies actively traded increase and decrease in value, through a process named "marked to market", through which profits and losses are immediately credited to or deducted from the trader's margin account.

Marked-to-Market

Changes in the value of a trader's open trades (positions) are normally reflected in the trader's account balance. This accounting, called "mark to market" can occur continuously in some trading platforms, or once per day in other platforms. The term refers to the days before computers, when the value of an asset was recorded, or marked, on a balance sheet at the end of each trading day. This practice continues today, electronically, and can have a noticeable impact on the account balance.

Glossary

For more trading terms, please browse through our extensive online glossary of forex trading terminology.
What is traded?

While almost any currency can be traded in the forex market, the most frequently traded currencies are referred to as the Major Currencies. Currencies are commonly abbreviated to a three-letter currency symbol. Major currencies include: the United States Dollar (USD), the Euro (EUR), the Japanese Yen (JPY), the Great Britain Pound (GBP), the Swiss Franc (CHF), the Canadian Dollar (CAD), the New Zealand Dollar (NZD), and the Australian Dollar (AUD). Other currencies can be considered to be Minor Currencies, sometimes referred to as "Exotic" or "Emerging" currencies

Currency Pair Symbols

Forex currencies are always traded in pairs, with one currency being bought and the other currency being sold. In forex trading, a small number of currency pairs make up most currency trading. Those pairs are often called "Major Pairs". While there is no official list of Major Pairs, a list of Major Pairs might include: EUR/USD, USD/JPY, GBP/USD, USD/CHF, EUR/GBP, EUR/JPY, EUR/CHF, AUD/USD, USD/CAD, and NZD/USD. Note that most of those pairs include the US Dollar or Euro. Currencies that do not include the USD or Euro are commonly referred to as "Cross rates" A few cross rates are popular, but many cross rates have less trading volume, and might be susceptible to increased spreads and dramatic price swings.

It is worth noting again, that the order of the currencies listed in the currency pair is important and meaningful. In addition, most trading between two currencies occurs predominately in a pair with a specific order. For example, US Dollar is traded against the Euro in the pair EUR/USD, not as USD/EUR. The preferred order of the pair was established by tradition and common practice. Of course, the order has no impact on the ability to trade the currency pair in either 'direction'. If a trader wants to buy Euros with US Dollars, he would sell.

How much does it cost to trade

Entering the forex market can cost very little. The capital required is the amount required by the brokerage for deposit in a margin account. Some brokers allow a minimum account balance (for the margin account) as low as $250.00. With leverage the amount of foreign currencies controlled by that minimum account balance can be large. In practical terms, trading with a minimum amount in the margin account can be risky. A small unfavorable change in currency rates can quickly deplete a margin account with a minimum balance.

In practice, the cost of each trade (before any profit or loss), is found in the spread (see above). Since a forex pair is purchased at the Ask price, and sold at the Bid price, there is a cost of trading that pair, which is the amount of the spread, multiplied by the amount of currency being traded. Normally, there is no commission charged for forex trading. The cost is limited to the spread. A common spread for major currencies might be 3 pips (or .0003). With that spread, there is a cost $30.00 for entering and exiting a trade of currencies valued at $100,000.