How to Read a Quote
Each individual currency is labeled with three capital letters. The first two letters identify the country and the last letter represents the name of the currency. For example, the Japanese yen is listed as JPY. The “J” and the “P” stand for Japan and the “Y” stands for yen. Currency pairs are quoted listing the base currency first and the quote currency second. The base currency is what the trader is buying or selling. The quote currency expresses how much of the quote currency is required to purchase one unit of the base currency. For example, if a quote is listed as 1.500 and the currency pair is USD/JPY, USD is the base currency, JPY is the quote currency, and it takes 1.500 JPY to purchase 1.000 USD.
The market participants can be organized into a hierarchy. The interbank market sits at the top. This market is comprised of mostly large banks and a few smaller banks who trade with each other electronically. The electronic trades are placed through the electronic brokering service or Reuters 3000 spot-matching. The banks in the interbank market trade with one another at a lower rate than the rest of the market because banks have higher credit quality. Medium and smaller banks are next in the hierarchy, followed by hedge funds, corporations, and retail brokers. These participants cannot trade in the interbank market. They need to use commercial banks which makes trading more expensive. Lastly, retail traders sit at the bottom of the hierarchy.
A trader has many different types of orders at their disposal. Let’s start with most simple order, called a market order. A trader places a market order to buy or sell a currency at the current market price. One issue with market orders is that there can be a slight delay in execution. If a trader places a market order it is possible for the price to change before the order is fully executed. Another type of order is a limit entry order. This is an order to buy a currency below market price and to sell a currency above market price. The opposite of a limit entry order is a stop entry order. A stop entry order sells currency below market price and buys currency above market price. If the trader believes a price will break through a support or resistance zone then he or she might place a stop entry order. One of the most useful tools for any trader, from amateurs to professionals, is the stop loss order. This order protects a trader’s floor. A trader should set a stop loss order at the maximum loss he or she will accept. If the price falls to where the stop loss order is set, the order will be executed. A trailing stop is a stop-loss order that trails behind the currency as price increases. If the price of a currency increases by 20 pips, a trailing stop-loss order will also increase by 20 pips.
Pros and Cons of Forex Trading
Ability to diversify: The forex market gives investors the opportunity to diversify their portfolios because it is historically uncorrelated with the asset market.
Alternate returns: When the stock and bond markets are down investors can turn to the FX market to earn higher returns.
Leverage: Leverage is easier to attain in the FX market. Leverage allows investors to earn greater returns, however, it does increase risk.
Low Barriers to Entry: Some online brokers only require a $25 minimum deposit. This allows people without large sums of capital to participate in the FX market.
Size: Since the FX market is so large, no single entity can take control of it. This means that nobody can control market prices for an extended period of time. The vast scope of the FX market also impacts liquidity. Traders can buy and sell with ease because there are so many market participants. A trader will rarely feel like he or she is “stuck” in a trade.
Free demo accounts: There are free demo accounts available that make it easy for investors to practice trading in the FX market. Investors can test out trading methods and strategies without risking real money.
Inconsistent returns: There is a lot of volatility in the FX market so periods of loss are unavoidable. To survive these challenging periods, investors must have a good risk management plan in place.
Scams: Investors must remain wary of scams. When starting out in the FX market it can be difficult to differentiate between legitimate FX companies and scammers. In general, if something seems too good to be true, it probably is.
Intro to Forex Terms
Bid price is the price one can sell an asset for in the marketplace. Ask price is the price one can buy an asset for in the marketplace. The bid price is typically lower than the ask price.
All of the major currency pairs include the United States dollar. Investors pay close attention to the USD because it is the most actively traded currency in the foreign exchange market. Currency pairs without the US dollar are called crosses. Lastly, an exotic currency pair consists of one major currency and one currency from an emerging country.
Leverage is the amount of money an investor borrows while using a small amount of his or her own money as a deposit. Banks set ratios for how much leverage a trader can take on. If the bank’s allowed leverage is 1:100, then a trader is only required to have one dollar for every one hundred dollars he or she borrows from the bank. Being highly levered gives investors the opportunity to earn much higher returns, however, it also adds a lot of risk
A standard lot size is 100,000. If a trader purchases one standard lot they will be purchasing 100,000 units. Lots come in smaller sizes as well. There are mini, micro, and nano lots that have the respective units, 10,000, 1,000, and 100.
Margin is the amount of money an investor must deposit to receive leverage from a bank. For example, if an investor goes to a bank that allows leverage of 1:100, the investor must give the bank $1 to receive $100 in leverage. The $1 the investor gives the bank is considered margin.
Brokers want to ensure that investors will pay them back. If a broker sees that an investor’s balance is falling too low the broker will make a margin call. This requires the investor to add more capital to the account. If the investor is unable to replenish the capital, the broker can close some of the investor's equity positions to cover the cost.
Investors place orders to enter and exit the market. Orders dictate when to buy and sell currencies.
Pips measure the change in value between two currencies. One pip is equal to 0.0001 units of the currency. If a currency’s price changes from 1.4550 to 1.4551, it increased by one pip.
A quote expresses how much of one currency is required to buy one unit of another currency.
Currency pairs are listed in a bid/ask format. The difference between the bid and the ask is considered the bid/ask spread.
A Swap is an agreement between two parties to borrow and lend currency. For example, there are two people who want to do a swap. Person A has USD and would like to borrow EUR. Person B has EUR and would like to borrow USD. So person A lends USD to person B, and person B lends an equal amount of EUR to person A. At a specified future date, person A must return the EUR to person B, and person B must return the USD to person A.
The costs associated with entering a trade are transaction costs. In foreign exchange, the transaction cost is the bid/ask spread plus any broker-specific commissions. In order to earn a profit on any trade, the return must at least cover the transaction cost.
Volatility measures price fluctuation. A volatile currency pair will experience frequent spikes and falls in price.
Where to Practice
A great way for new investors to practice forex trading is by creating a demo account. This gives investors the opportunity to interact with live market movements and practice investment strategies without risking real money. It is important to note that a demo account does not prepare a trader for the emotional impact of losing real money. A trader needs to be ready to stomach a loss and continue making logical investment decisions.