If you are interested in trading forex, you must understand the terminology used in the industry. Like most professions, forex trading has its own set of terms and acronyms that can confuse beginners. However, understanding these terms is essential to being successful in this field.
In this friendly beginner guide, we will help you learn the lingo of forex trading to trade effectively and understand the market better.
Let’s get started!
A pip is the smallest amount by which a currency quote can change. In the context of forex trading, a pip (short for “percentage in point”) refers to the smallest unit of measurement of a currency’s value. It is used to describe the change in the price of a currency pair and is usually expressed in decimal points.
A single pip equals 0.0001 of the quote currency (the second currency in the pair) for most currency pairs. However, for currency pairs that include the Japanese yen as the quote currency, a pip is equal to 0.01 due to the different decimal place conventions used by the Japanese yen.
Pip values are essential for forex traders, as they help determine a trade’s profit or loss. However, the value of a pip depends on the trade size and the exchange rate of the currency pair being traded.
For example, if a trader buys 1 standard lot (equivalent to 100,000 units) of USD/JPY (assuming a current exchange rate of 109.35) and the price moves up by 1 pip, the profit would be 1000 yen (since a pip for USD/JPY is 0.01).
In the forex market, a ‘lot’ refers to the standardized quantity of the underlying asset a trader buys or sells. The size of a lot depends on the type of account that a trader has and can vary widely between different brokers. Therefore, understanding how lot sizes work in forex trading is crucial as it can significantly impact your trading strategy and risk management.
Traders use three common types of lot sizes: Standard, Mini, and Micro lots. A standard lot size is the most commonly used lot size. It represents 100,000 units of the base currency in a currency pair.
A mini lot in forex represents 10,000 units of the base currency. In other words, 1 mini lot of USD/JPY means USD 10,000. Additionally, a micro lot is the smallest lot size available in forex trading and represents 1,000 units of the base currency.
A currency pair refers to the exchange rate between two currencies, indicating how much of one currency is needed to purchase one unit of another currency.
Currency pairs are always listed in a specific format, with the base currency listed first and the quote currency listed second. For example, in the currency pair EUR/USD, the euro is the base currency, and the US dollar is the quote currency.
Most forex brokers offer three main currency pairs categories: major, minor, and exotic. Major currency pairs are the most widely traded, including EUR/USD, USD/JPY, and GBP/USD.
Minor currency pairs, called cross-currency pairs, include currencies other than the US dollar, such as EUR/GBP or CAD/JPY. Finally, exotic currency pairs feature currencies from emerging market economies, such as the Turkish lira, South African rand, or Mexican peso.
In forex trading, the “spread” refers to the difference between the bid price and the asking price of a currency pair. The bid price represents the highest price that a buyer is willing to pay for a currency, while the asking price represents the lowest price that a seller is willing to accept for that same currency.
The spread is a forex broker’s commission on each trade, as they often charge traders a small fee for executing a trade. The spread can be fixed or variable, meaning it can remain constant or fluctuate depending on market conditions.
For example, if the bid price for EUR/USD is 1.1200 and the asking price is 1.1205, the spread would be 0.0005 (or 5 pips). It means that a trader would need to earn at least 5 pips on the trade to cover the cost of the spread and break even.
The size of the spread is determined by several factors, including the currency pair’s liquidity, the market’s volatility, and the broker’s pricing policy. Generally, more heavily traded currency pairs tend to have lower spreads than less popular ones.
In the forex market, a bid is the price at which a trader or market maker is willing to buy a currency pair from the investor or trader. On the other hand, the ask refers to the price at which a trader or market maker is willing to sell a currency pair to the investor or trader.
The bid and ask prices are crucial to understand in forex trading as they represent the basic information used in forex charts and to execute trades. Moreover, the difference between the bid and ask prices can vary widely between different currency pairs and brokers, emphasizing the importance of considering these factors when choosing a broker.
Margin and Leverage
Margin refers to the amount of capital a trader must deposit to open and maintain a trading position with their broker. It is a form of collateral that the broker holds to cover any potential losses that may occur due to the trader’s position.
Margin is typically expressed as a percentage of the full value of the position. For example, if a trader wishes to open a position worth $100,000 and the margin requirement is 1%, they would need to deposit $1,000 in the margin with their broker. The amount of required margin can vary depending on the broker and the size of the position being traded.
Margin is essential in forex trading because it allows traders to take advantage of leverage, which is the ability to control more prominent positions in the market with a relatively small amount of capital. For instance, if a trader has a leverage ratio of 100:1, they can control a position worth $100,000 with just $1,000 in margin.
On the other hand, leverage is a tool that allows traders to control a prominent position with a small amount of money. For instance, if a broker offers a leverage of 100:1, a trader can maintain a $100,000 position with just $1,000 in margin. Also, if a broker offers a leverage of 50:1, a trader can control a $50,000 position with just $1,000 of margin. While leverage can magnify profits, it can also magnify losses if the trade goes against the trader.
Stop Loss and Take Profit Order
A stop-loss order is an order that specifies the maximum loss a trader is willing to take on. For example, in forex trading, stop loss and take profit are two orders traders can use to manage their trades and minimize potential losses or lock in profits.
A stop-loss order is an instruction to close a position when the price of the currency pair reaches a specified level that is less favorable to the trader. For example, if a trader buys EUR/USD at 1.1200 and sets a stop loss order at 1.1100 if the price falls to 1.1100, the position will be automatically closed, limiting the loss to 100 pips. Stop-loss orders are an essential risk management tool as they can prevent traders from experiencing significant losses if the market moves against their position.
On the other hand, take profit order is an instruction to close a position when the currency pair’s price reaches a specified level that is more favorable to the trader. For example, if a trader buys EUR/USD at 1.1200 and sets a take profit order at 1.1300 if the price rises to 1.1300, the position will be automatically closed, locking in a profit of 100 pips. Take profit orders help traders exit their trades at a predetermined level rather than being tempted to hold onto their position for longer to make greater profits.
The trader sets both stop loss and takes profit orders when they enter the trade. They are essential tools for managing risk and ensuring traders have a clear trade exit strategy. It is vital for traders to carefully consider their risk tolerance and trading strategy when setting these orders, as they can significantly impact their ultimate trading performance.
To be a successful forex trader, you need to start y familiarizing yourself with the fundamental concepts introduced in this guide; you can improve your ability to analyze market trends, interpret news events, and make profitable trades. Remember that forex trading requires discipline, patience, and a willingness to learn. With the right mindset and foundational knowledge, you can chart a course toward success in the exciting world of forex trading.