Essential Forex Terms Every Trader Should Know
Let’s introduce some basic forex terms using an example.
If an American tourist plans to visit France, he will sell dollars to buy euros. This transaction will be made at a specific exchange rate, and the currency pair to be traded is EUR/USD. If the tourist wishes to exchange $1,000 at $1.1500 per euro, he will leave with approximately €870 ($1,000 / 1.1500 = €869.57). Suppose the trip is canceled, and the euros must be exchanged back for dollars. The exchange rate has already changed to $1.2000 per euro. In this scenario, the tourist would receive €870 * 1.20 = $1,044 (a profit of $44).
Base and Quote Currencies
The first currency in a pair is called the base currency because it indicates its unit value measured in another currency. Thus, in the example above, one euro (the base currency) was initially equal to $1.15. Subsequently, one euro is worth $1.20. The second currency in the pair is the variable that determines whether the base currency appreciates or depreciates. For this reason, the second currency in the pair is called quote currency. In the above example, the base currency (euro) has appreciated, and the quote currency (the dollar) has depreciated.
Long Position / Short Position
These two terms are synonymous with buying and selling a particular currency pair. We are “long” when we have bought a certain amount of the base currency, and we are “short” when we have sold the base currency. Thus, when we open a long position in EUR/USD, we will profit from the euro’s appreciation.
Bid Price / Ask Price
For each currency pair, the broker provides two different quotes—on one, he buys (bid price), and on the other, he sells (ask price). It is important to remember that buy/sell actions are implemented from the broker’s perspective and refer to a unit of the base currency—in this case, the euro.
In the above example, the American tourist purchased euros at 1.1500, i.e., the broker sold at the “ask price” (or offer price) at an exchange rate of $1.15 for each euro. Subsequently, the reverse transaction was implemented—the broker bought euros from the tourist, i.e., the broker’s “bid price” was $1.2000 per euro.
Bid / Ask Spread
The difference between the bid and ask price is called the bid/ask spread. The buy rate (bid) is always lower than the sell rate (offer), eliminating the possibility of making a risk-free profit by simultaneously buying and selling a pair.
Let’s return to the example above, assuming that the “bid price” for EUR/USD is 1.1490 and the “ask price” is 1.1500. The broker sells the euro at $1.1500, and the tourist buys accordingly at these levels. For his $1,000, the tourist gets €869.57 ($1,000 / 1.1500 = €869.57). If, at the same time, he decides to sell his euros back for dollars, the transaction will take place at $1.1490 per euro. Thus, he would receive $999.14 (€869.57 x 1.1490). A minimal loss (the bid/ask spread) is realized due to the simultaneous execution of the two opposite transactions.
The spread is a significant source of income for brokers. Depending on the currency pair, it can be narrower or wider. Logically, the more liquid a currency pair is, the lower its spread is.
Pip
The pip is the unit of measurement for the smallest change in the value of a currency pair and is reflected in the fourth decimal place (0.0001) of prices. If the EUR/USD exchange rate changes from 1.1500 to 1.1501, the change will equal one pip. Exceptions are the Japanese yen currency pairs, where the pip is reflected in the second decimal place. The change in USD/JPY from 120.00 to 120.01 equals one pip.
Given the growing competition between different brokers and narrowing spreads, we often see quotes with five decimal places. The fifth digit is called a point. For example, a change in the EUR/USD exchange rate from 1.15005 to 1.15015 represents a change of ten points (one pip). In JPY pairs, quotes of three decimal places are frequent (120.001).
For more significant price changes, traders use the term “figure.” One figure is equivalent to 100 pips.
Lot
Most brokers offer standardized trading volumes. The lot represents the number of units of the base currency to be traded. The standard lot equals 100,000 units, the mini-lot equals 10,000 units, the micro-lot is 1,000 units, and the nano-lot is 100 units.
Conclusion
The terms above are some of the most encountered in analyses and publications. Trading on a demo account allows one to gain experience determining desired trading volumes, calculating bid/ask spreads, and understanding pips.
