Basic terms of forex trading
This article will cover the following
- How currencies are traded in the market
- How currency values movement is measured
- What is a spread and why is it important
- Bulls and Bears – what are they
- Positioning in the market
In this article we will outline the most important terms, which are an integral part of the world of Forex trading.
What are the so-called currency pairs?
When a beginner is confronted for the first time with a platform for trading currencies, he/she will undoubtedly notice that each world nation currency trades in pairs with another. That is why they are known as currency pairs. Each of the pairs consists of one base currency and one counter currency (quote currency).
Best Forex Brokers for United States
If we take, for example, GBP/USD pair, here the United Kingdoms pound (GBP) stands for the base currency and the United States dollar, also known as ”greenback”, stands for the counter currency.
In Forex trading, as in stock and commodity trading, one can notice one single price, announced for each currency pair. In the case of trading currency pairs, a trader purchases or sells the base currency in relation to the counter currency. In our example, we do not simply buy the British pound, we buy the pound with a specific amount of US dollars.
If GBP/USD pair currently trades at 1.6395, this means that 1.6395 units of the counter currency (USD) are currently needed to satisfy the trade for 1 unit of the base currency (GBP).
In case the US dollar gains strength, then it will be possible to say that a lesser amount of US dollars may purchase a greater amount of British pounds. However, because of the increased value of the US dollar and because it is denoted in relationship to the pound as a counter currency in the pair, GBP/USD pair tends to decrease. If it was previously trading at 1.6395, because of the strenghtening US dollar it is now trading at 1.6380, for instance, or a lesser number of units of US dollars now buys 1 unit of British pounds.
Another crucial moment, when trading currency pairs, is that a trader does not have to possess US dollars in order to purchase the GBP/USD pair. He/she may begin trading with euros and purchase GBP/USD, because his/her euros are converted into US dollars, which are then used to buy British pounds.
What is a pip?
In Forex trading, the movement in prices of currency pairs is measured in ”pips”. A pip is an acronym for the phrase “percentage in point”. This is the smallest price change, which a given exchange rate can make. Most major currency pairs are priced to four decimal places, so in this case, the smallest change is that of the last decimal point – for most pairs this is the equivalent of 1/100 of 1%, or one basis point.
If GBP/USD is currently trading at 1.6370 – the last number (0) is the pip. If the value of the pair increases from 1.6370 to 1.6371, then it has increased by 1 pip.
Traders in the Forex market usually measure their profits/losses in pips. If a trader purchases GBP/USD at 1.6370 and the value subsequently climbs to 1.6390, this means that the value has increased by 20 pips, while the trader obtains 20 pips of profit.
Some trading platforms break the value of currency pairs down even more, including a fifth number, which is called a pipette. For example, the platform will show the value of GBP/USD as 1.63708, or with a fifth number after the decimal.
It is useful to mention also, that Japanese pairs are showed in a slightly different way, with the pip being the second number behind the decimal, while the pipette – the third. If the value of USD/JPY pair is presented as 101.548, then the number 4 is the pip and the number 8 is the pipette.
The importance of spreads
In Forex trading the spread represents the fee (commission), which any broker will charge you every time you enter a trade. Newbie Forex traders usually tend to underestimate the importance of the spread, but this is actually one of the most important factors according to which you should choose your Forex broker.
Let us provide an example of what a spread is. If GBP/USD pair currently has a value of 1.6350 and you intend to buy this pair at this price, your broker will not sell it to you at 1.6350. The broker will submit you a quote slightly higher, for instance, 1.6352. In case you intend to sell this pair, then you will be given a quote slightly lower than 1.6350, say 1.6348, or the value at which your broker will purchase the pair.
As you can see there is a difference between the two quotes (1.6348 and 1.6352). The difference, at the amount of 4 pips, represents the spread. This is the difference between the price at which the broker is willing to buy from you and the price at which he is willing to sell to you. As the broker buys from you at a lower price and sell to you at a higher price, he makes a profit.
Many trading strategies and systems depend strongly on spreads, and most often a very high spread may render a trading system useless. If the trading system involves entering many positions in small periods, then it is highly recommendable that you find a broker offering low spreads.
The spread value is different for each currency. Volatile currency pairs commonly have a tighter spread, while crosses suffering low liquidity usually have a higher spread. This is one of the main reasons why the majority of traders prefer to trade pairs such as the EUR/USD, since its spread is relatively thin, which renders it especially suitable for scalpers who enter many position each day and need the lowest spreads possible. We shall examine the behavior of scalpers at a later time.
Bid and Ask
Bid stands for the best possible price, at which a given instrument being traded at the present moment, can be purchased by a trader. In Forex trading world bid price refers to the highest price, which the broker is willing to pay in order to purchase the instrument from the trader.
Ask price stands for the best possible price, at which a given instrument being traded at the present moment, can be sold by a trader. In Forex trading world ask price refers to the lowest price, at which the broker is willing to sell the instrument to the trader.
Trading instruments (Assets)
By trading instruments or assets, we refer to the items that are being traded at the moment. If we are currently trading gold, then gold is the trading instrument. If we are currently trading a currency pair (USD/CAD, for example), then the currency pair is the trading instrument.
Opening and closing a position. Entry and exit
If a trader has purchased or sold a trading instrument, than he/she has opened a position in the market, or he/she has entered the market. If a trader has exited the market, then he/she has closed a position.
If a trader has decided to open a position by purchasing or selling a trading instrument in the market, then he/she has made an entry.
If a trader has decided to close a position in the market and register a profit or a loss, then he/she has made an exit from the market.
Stop loss and profit target
A stop loss is a term, used to point out how to exit the market in a situation, when a trade has gone awry. Let us imagine a trader, which has opened a position buying an instrument in the market, but the trade develops in a wrong direction and he/she starts to lose money. If the position remains open and the price continues going in the opposite direction, it is possible the trader to lose most or all of its deposited funds in his/her trading account.
A stop loss order actually prevents the trader from suffering heavy losses. This order will automatically close the position, once a specific price has been reached. We shall examine the basic types of orders, which a trader can submit in order to start trading in the market later.
Profit target refers to the price, at which a trader is willing to exit the market and lock in the profit he/she has registered. This target is usually set by the trader before he/she decides to enter the market. In this case, before making an entry, if the trade develops as expected, the trader already knows how much he/she will profit from this trade.
Bear market versus Bull market
One of the most important things one needs to consider when investing in a certain market is whether prices are trending up or down. Sometimes however, the market may move with no distinct direction, or as many people refer to it “trade sideways”. Prices which fluctuate without any noticeable trend are very hard to predict and respectively difficult to profit from, which is why beginner traders are advised to avoid investing during such market movements.
When we have a distinctive trend however, the market can move in two possible directions – up or down, or as it is most often referred to – a bull or bear market.
A bull market is a financial market of any kind in which prices are rising or according to broad expectations will rise. The word “bull” used to describe such a market comes from the way bulls charge and thrust their horns from below into the air, whereas bears swipe their paws down toward the ground.
Bull markets are characterized by strong investor confidence, optimism and sentiment that the strong performance will continue. “Bullish” investors, lured to the market as momentum picks up, charge in and buy assets amid expectations that prices will continue to rise and they can later resell those assets at a higher price, profiting from the difference.
Likewise, the term “bear market” describes a time when stock prices have been falling as a whole. A bear market is dominated by widespread pessimism which causes a self-sustaining negative sentiment. As investors become more and more pessimistic amid expectations losses will extend, they continue to sell and fuel further sell-offs.
A “bearish” investor who wants to profit when prices are trending down will enter a short position, betting that prices will extend losses. “Shorting” however requires more practice to manage and isnt suitable for inexperienced traders.
Types of Positions
There are two types of positions when trading on the markets – long and short. Taking a long position means you are buying an instrument with the intention to sell it later, after it has gained, and earn through the price difference. Other terms that are often used as synonyms are: long side trading, trading on the long side of the market, going long the market etc.
Taking a short position means you are betting that prices will drop and you are selling. Basically, when going into a short position, you borrow, for example stocks, from a broker and you sell them on the market. Later, you have the obligation to return what you have borrowed by buying it from the open market and you will profit, if prices have dropped. The idea is to sell something you have borrowed now for a certain amount of money and later refund the broker by buying the same thing at a lower price.
Let us have an example. An investor places an order, which is immediately executed, to sell short 100 shares of XYZ Corp. at $25.00 per share. The investor will receive a cash inflow of $2 500 from this transaction.
Now let us assume that two weeks later, the price has indeed dropped, and that the investor is able to buy back the shares (also known as covering a short position) for $20.00 per share. In this transaction, he will have to spend $2 000 to repurchase these shares. His profit on the trade will be $500 ($2 500 initial cash inflow minus an eventual $2 000 cash outflow). The other way to look at this is that he will have earned $5 per share on the trade, which will provide him with a profit of $500 ($5 gain multiplied by 100 shares).
Short-selling of currencies differs from “shorting” stocks
Beginner traders should pay attention to the fact that short selling a currency pair differs from short selling a stock. Within the pair, currencies are traded one against the other. If we choose to trade GBP/USD and enter a long position in this pair, then we are actually buying the British pound and selling (shorting) the US dollar. If we are to enter a short position in this pair, then we do the opposite – we are buying the US dollar and selling (shorting) the British pound. Now we are short selling GBP/USD pair.
The very first step most new traders will want to take from the get-go is to dive into the market, and immediately enter into their first Forex position as quickly as possible. Having understood the majority of basic terms and how to enter a position, a beginner trader should also be aware of the risk management aspect of their trading idea.
Proper risk management is imperative to any trading plan, and allows the trader to know exactly where he/she wishes to exit the market in the event that price turns against him/her. Thats why well focus on better understanding the Risk/Reward ratio.
The Risk/Reward ratio refers to the amount of profit an investor expects to gain on a position, relative to what he is risking in the event of a loss. Knowing this ratio can help traders manage risk by setting expectations for the outcome of a trade prior to entry. The key here is to find positive ratio for your strategy. This way he increases the margin of profit when he is right, relative to the amount he loses if was wrong.
Number one mistake
Understanding these ratios can actually help newbies avoid the number one mistake that traders make. After reviewing more than 12 million trades, analysts were able to calculate that while most trades are closed at a profit, losses still far exceeded profits due to traders risking more on losing positions than the amount gained from a winner. This statistic shows that most traders are using a negative Risk/Reward ratio which requires a much higher winning percentage to compensate for their losses.
An example to avoid this scenario is to use at minimum a 1:2 Risk/Reward ratio. This maximizes profits on winning trades, while limiting losses when a trade moves against you. For example, if the trader expects a trade will likely produce at least double the amount risked, this would be referred to as a 1:2 Risk/Reward Ratio. Many look for this ratio to be at least 1:3 before taking a position in the trade.