Foreign Exchange (Forex) Terms
There are many terms that are commonly used in forex, and it's important to know them in order to properly understand what is going on. Some of the most commonly used terms are defined below.
A pip in forex is simply .0001% or 1% of 1%. Most quotes for currencies are stated in this type of format. So if an exchange rate of EUR/USD changed from 1.5067 to 1.5072, then the exchange rate increased by 5 pips.
Currencies are often traded in set amounts. For individual investors, the most common lot size is a standard lot, which is 100,000 units. A mini lot is 10,000 units, micro lot 1,000 units and a nano lot 100 units. The institutional FX market trades in 1,000,000 units, although trades are priced to any amount a customer would like to trade.
Standard trade sizes are used to enable market makers to supply liquidity more easily. Buyers and sellers are more easily matched trading standard amounts.
Major currencies are the most common currencies traded in the FX market. These are US dollar (USD), Euro (EUR), British Pound (GPB), Swiss franc (CHF) and the Japanese yen (JPY), and the Canadian dollar (CAD). These are the most liquid currencies since they are the ones that are traded most often. Major pairs are any pairs that involve the USD and any one of these currencies.
Minors are any currencies that aren't one of the major currencies. There are many different minor currencies but they make up a very small volume of the FX market.
Currencies are quoted in pairs. The first currency in the pair is the base currency. The second currency to be quoted is the quote currency. Currencies are normally stated as how much the base currency costs using the quote currency. For example, if a currency quote says USD/CAD 1.0432, then the USD is the base currency and the Canadian dollar is the quote currency. You can buy 1.0432 Canadian dollars with 1 USD.
Bid and Ask
The bid price is the price that you can sell a currency, or in other words, the price that the market will pay for a currency. The ask price is the price at which you can buy a currency, or the price that market is willing to sell it at. Normally the bid price is lower than the ask price.
Currency pairs are stated in the format: bid / ask. The difference between the bid and the ask price is called the bid/ask spread. A broker will buy a currency from a client at the lower bid price and then sell it at the higher ask price without any changes happening in the market. Normally the bid/ask spread is very small.
Transaction costs are any costs that are involved with trading. In foreign exchange the transaction costs are the bid/ask spreads. Trading commission, like those charged in the stock market, are used rarely in the foreign exchange markets. Both are examples of transaction costs. A successful trader will pay close attention to transaction costs because they have a negative effects on returns.
Currency cross rates are currency pairs that don't involve the USD. For example, EUR/JPY would be considered a currency cross as it doesn't involve the dollar, and also happens to be one of the most commonly traded currency pairs.
Leverage is when a trader borrows money, multiplying their risk and return for their portfolio. Margin is the amount of your initial investment relative to the amount of money that you can control in a portfolio. For example, if you have a $1,000 with leverage of 10 to 1 (10:1) you can control up to $10,000 in your account.
Margin and Margin Calls
A margin call occurs when the amount of margin in an account falls to a pre-determined level requiring the account to be replenished. For example, if a broker states that a margin call happens when your losses exceed 50% of your initial investment and you invested $1,000 initially, then a margin call happens when your account balance drops below $500. Traders can pare positions or add fresh margin to prevent margin calls. If a trader does not promptly increase the margin held in an account following a margin call, the broker usually has the right to liquidate the traders positions to protect it from further losses. (The remaining balance in your account is returned to you.) Brokers put margin calls in place in order to protect themselves from clients not being able to pay them back when their clients' losses exceed their initial investments from using leverage.