Part 1 - How to read a currency quote

Forex trading is a form of commodity trading. In the commodity market traders buy and sell assets like oil or gold in exchange for currencies. In the forex (currency trading) market the assets bought and sold are currencies themselves. As a result, unlike in the commodity, each currency’s value is determined relative to another. For example, when the currency trader buys an ounce of gold, he must pay for it with the US dollar, which creates a quote in which the price of the metal is defined in terms of a currency which is another asset class. But when the forex trader buys or sells the Euro, he must pay for it with another currency (Australian dollar, Swiss Franc, etc) in which case the quote created has the same asset class on both sides. The result of this is that it is impossible to speak of absolute value in the forex market because it is possible to value the Euro in dollars, Francs, or Yen, each being a valid choice as a value indicator. In the case of stocks, or commodities, the value can only be indicated in USD; therefore it is possible to speak of an absolute value.

Upon downloading and opening the software of your chosen forex broker, the first concept that you will encounter is the forex price quote. The quote is simply the record of a previous transaction in which a currency pair changed hands. When two financial actors exchange currencies, the price at which the transaction occurred is called a quote. Let’s see this with an example.

EUR/USD 1.3524

n the above quote, the currency on the left side is the currency which was bought by us, while the one on the right is the one that we sold to finance our purchase. The number signifies the value at which the currencies were exchanged. Or to put it in a short and simple mathematical form, when we bought 1 Euro, the value of one Euro was equal to 1.35 USD, and we had to pay that much to buy the currency.

Upon executing the trade, we are now long the Euro, and short the dollar (we bought the Euro, and sold the dollar.), in either words, we have an open position.  The principle of profit in currency trading is the same as in all other kinds of trading activity: to buy cheap, and to sell expensive is our purpose. Consequently, we will wait for the value of the Euro to rise above 1.35, to for instance, 1.38, where we will be able to close our position by selling the Euro and buying back the dollars, and making a profit. Since our base currency is the dollar, our profit will also be measured in dollars.

Let’s solidify this with an example:

We buy 1,000 EUR for 1,350 USD, with the quote at 1.35. We wait until the quote is at 1.38, when we close our position by selling our 1,000 Euro at 1,380 USD. Since our initial trade was worth 1,350 USD, the difference between 1,380 and 1,350, that is, 30 dollars, becomes our profit.

Part 2 - What are Trading Pips, Lots, Margin and Leverage

Pips and Lots

Currency traders quote the value of a currency pair, and trade sizes, in pips and lots. A pip is usually the smallest amount by which the value of a currency pair can change, although these days some brokers offer fractional pip quotes too. In example, when the value of the EUR/USD pair goes up by one tick (i.e. pip) the quote will move from 1.2345, to 1.2346, and the size of the movement is just one pip. An important guideline for the beginning trader is to measure success or loss in an account by pips instead of the actual dollar value. A one pip gain in a $10 account, is equal, in terms of the trader’s skill, to a 1 pip gain in a $1,000 account, although the actual dollar amount is very different.

The smallest size in currency trading for professional traders is called a lot. For USD-based pairs, the lot size is 100,000. In other words, when you enter a trade with your margin account, the smallest amount that you can buy or sell is 100K, regardless of the size of your margin.

Margin and Leverage

Another important concept in currency trading is the twin phenomenon of margin and leverage. This is a concept that carries a high degree of risk, but since forex prices move very slowly (in terms of the actual change in value), the vast majority of traders leverage their accounts when engaging in short-term trading.

When you open a forex account, the broker will request that you deposit a small sum, known as margin, as insurance against the losses that your account may suffer. With this small sum, you’re able to control a much larger amount, enabling greater gains, but also greater losses than you would be able to achieve with your deposit. It’s easier to understand margin and leverage in the context of a borrowing process. The lots that you can trade are borrowed from your broker, who requires a margin deposit as an insurance against losses. The ratio between the funds borrowed by you, and the margin that you deposit as insurance is called leverage. Thus, if you set a leverage ratio of 100:1, enabling the trade of 1,000,000 USD with just 10,000 USD in deposit, but eventually trade just 100,000, the actual leverage that you would be using is 10:1. Note that leverage over 50:1 for majors and 20:1 for minors is not available to traders in the U.S. 

In order to understand how to manage your account you must gain a good understanding of leverage. Failure to pay proper attention to leverage and margin may result in a margin call and the broker may liquidate your position in order to ensure that your losses do not reach a level where your margin deposit is insufficient to cover them. Increasing leverage = increases risk.

Next, part 3 >> Order Types - Mechanics of Online Trading >>