The Essential Guide to Understanding Forex Terminology

Forex trading

Forex trading means foreign exchange trading and describes transacting in the largest and most liquid market globally. There is more than 5-trillion a day in notional value traded in the forex market. The securities that are used to make trades are currency pairs.

A currency pair describes the relative value of one currency to another which is formed by creating an exchange rate. When you trade a currency pair, you are always buying one currency and selling another currency. To calculate the exchange rate of a currency pair like the EUR/USD (Euro versus the US Dollar) you divide the Euro by the US Dollar.

The Spot and Forward Market

The most liquid forex market is the spot market. In the spot market you are obligated to deliver the currency you are selling in two business days and required to receive the currency you are buying at the same time. If you make a spot trade, you execute the trade at the spot rate.

If you enter into a transaction that is longer than two business days, you are trading in the forward market. To get a forward rate, you add or subtract forward points to or from the spot rate. If you are in a forward position and you decide you want to continue to hold your positions, you need to rollover your trade. This is the process of moving your position to the following delivery date.

Spreads and Commissions

Your forex broker will provide you with quotes that will allow you to execute transactions. Generally, brokers will quote a spread, which is the difference from where they will buy and sell a currency pair. A broker will tell you their bid price, where they will purchase a currency pair, and an offer price, where they will sell a currency pair. Your broker is a market maker, and you are a market taker.

If you want to sell a currency pair, you can put in a limit order, at a specific exchange rate. Alternatively, you can enter a market order. With a market order, you are selling on the bid and buying a currency pair on the offer. Some brokers also have commissions, which is an additional charge to place a transaction. Futures trades generally have commissions in addition to a bid-offer spread.

Majors, Crosses, and EM Currency Pairs

Each currency pair is security.  The most liquid currency pairs are the major currency pairs. The major currency pairs have one of the following currencies as part of the pair.

• Euro
• British Pound
• Swiss Franc
• Japanese Yen
• Australian Dollar
• Canadian Dollar

To be considered a major currency pair, one of the two currencies must be the US dollar. If the currency pair does not have the US dollar as one of the components, the currency pair is a cross currency pair. When the currency pair is not a major and the US dollar is one of the components, the currency pair is referred to as a minor currency pair. This is only true if one of the two currencies is not an emerging currency from an emerging market. For example, the Brazilian Real would be considered an emerging currency. The Norwegian Krona is considered a minor currency.

Price Movements

The smallest increment that a currency pair can move is referred to as a pip. This stands for percentage in point. A pip is generally used to describe the bid/offer spread. For example, a 1-pip bid-offer spread would be considered very tight. Pips are also used to describe the amount of profit you are attempting to generate. For example, a trader might say I want to make 50-pips on this trade. When a currency pair moves 100-pips it is referred to as a big figure.

Slippage

When you place a trade, you are not always guaranteed that you will receive the price that is listed as the bid or offer. In fact, if a market is volatile, you might experience slippage. This is the amount that a currency pair moves on average when you go to place a trade.

Slippage occurs for many reasons. If you are placing a stop loss at key support or resistance levels, you are likely to experience slippage as many people are trying to exit at the same time. When large trades move through the market and volume increases, the chance of slippage increases.

Leverage

Leverage is the ability to increase the size of your trade without putting up additional capital. With leverage, your forex broker will lend you money to increase the size of the trade. Leverage will change based on the liquidity of the currency pair you are trading. The major currency pairs generally have the highest leverage opportunities, while emerging pairs generally have the lowest leverage rates.

Sentiment

Markets fluctuate 6-days a week, 24-hours a day. The ebbs and flows of intra-day movements are driven by market sentiment. This is also viewed as the psychology of market participants which changes based on technical analysis and new information.

Risk

When you transact in the forex markets, you are taking on risk. Risk is defined as the potential to lose money. There is a risk-free rate of return, which means that you are taking no risk. For example, if you invest in the US 1-year treasury bill, you will earn 2.4%, and the only risk is the credit of the United States Government. If you want to earn more, you need to accept risk.  If you are risk-averse, you are best off with safe bets like treasury bills.

Forex trading terminology is vast and it’s worth taking the time to learn about the more frequently used terms. The Trading Academy on One Financial Markets is a great place to become more familiar with specific trading jargon.

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