Trading currency is a process of exchanging one currency for another, so
each currency trade is actually two transactions happening at the same
time. One currency is bought while the other is sold. The forex market
quotes prices as currency pairs to facilitate the ease of trading one currency
for another. The quote of a currency pair represents the number of units
of one currency that are required to buy or sell the equivalent amount of
the other, based on the given exchange rate. For example, if the exchange
rate between the U.S. dollar and the Canadian dollar is $1.12, a trader may
purchase 1.12 Canadian dollars for every one U.S. dollar, or she can buy
one dollar for every 1.12 Canadian dollars. Your goal as a currency trader is
to hold the currency you believe will gain value against the other currency
quoted in the pair. It really is as simple as that.
Currency Pairs
Each currency pair is made up of two parts: the base currency and
the quote currency. For example, the U.S. dollar/Canadian dollar example
we just discussed is paired as USD/CAD. The base currency is always to
the left of the slash (/) mark; the quoted currency is always to the right ofthe slash. It is the direction of the base currency you consider when deciding
whether to buy a currency pair or sell it. If you believe the base currency
will appreciate against the quoted currency, you will buy the currency pair.
If you believe the base currency will depreciate against the quoted currency,
you will sell the currency pair. This is an important distinction for
new traders to remember because it is easy to buy by accident when you
meant to sell. Currency pairs offered on the forex market are constructed
using currency from both developed and emerging markets.
Table 1.4 lists the most common currencies, their countries, and their
International Standards Organization (ISO) codes used in the forex market
to construct currency pairs.
Major Pairs Major currency pairs are created by pairing currencies
from countries with highly developed economies and financial systems.
Major currency pairs are the most liquid and heavily traded currency pairs
on the forex market. Currencies among the majors include the euro, U.S.
dollar, British pound, Swiss franc, Japanese yen, Australian dollar, and
Canadian dollar.
Cross-Pairs Some currencies are not directly quoted against each
other; rather, they are synthetically traded by combining two different
pairs. These pairs, known as cross-pairs, include currency pairs such as
GBP/JPY, EUR/JPY, EUR/CHF, and GBP/CHF. When a trader executes a
trade to buy GBP/JPY, the trade is really constructed by buying GBP/USD
and selling USD/JPY. The dollar component of this trade is equaled out and
the trader ends up long GBP and short JPY. Because these pairs are constructed
with two different currency pairs, the spread or cost to trade across-pair is significantly more than a typical major currency pair, such as
EUR/USD.
Currency Lots
Currencies are traded in standard lot sizes to facilitate efficient trading
on the forex market. The standard retail lot is 100,000 units of the base
currency. Most currency dealers offer 10,000-unit mini lots and 1,000-unit
micro lots. Some currency dealers offer a 100-unit nano lot. Positions can
be sized larger by purchasing multiple lots. Fortunately, you don’t actually
need $100,000 in your trading account to buy a single standard currency
lot. Currency dealers offer various levels of leverage, allowing you to control
full-sized lots with significantly less capital in your account. We discuss
margin and leverage later in this chapter.
How a Currency Trade Works
The way a currency is simultaneously bought and sold during a trade is confusing
for many new traders, so an example will help clarify what happens
under the hood of a currency trade. Assume for a minute that you are interested
in buying the British pound against the U.S. dollar, which is listed
as GBP/USD in your trading software. The base pair is the British pound;
the quoted pair is the U.S. dollar. If the quoted exchange rate is $1.59 and
you are trading one standard lot of currency, it will require 159,000 dollars
to buy one British pound, or it will require selling 100,000 pounds to buy
159,000 dollars. Since we are interested in buying the pound, we want the
exchange rate to increase, allowing us to sell our pounds at a higher rate
for more dollars than we sold to buy the original 100,000 pounds. As an
example, Table 1.5 illustrates how a currency trader realizes a profit or a
loss using a single standard lot GBP/USD currency trade.
What Is a Pip? The term pip is an acronym for percentage in points
and is used to measure the change in exchange rates on the forex market.
A single pip represents the smallest possible decimal change a currency
quote may move, and it is the standard on which profit and loss are
calculated. Currencies are quoted in decimal format to 1/1,000th of a percent
unless the currency pair contains the Japanese yen. Currencies quoted
against the Japanese yen are in decimal format to 1/100th of a percent.
Using a quote for GBP/USD as an example, a change in price from $1.5600
to $1.5650 represents a change of 50 pips.
Long versus Short The terms long and short simply refer to the position
a trader has taken with a trade; the trader has either bought or sold it.The term long simply means that you have bought the currency; the term
short means you have sold it. For example, if a trader decides to buy
GBP/USD, it means she has gone long British pounds and short U.S. dollars
because she has bought the GBP and sold the USD.
Understanding Currency Quotes
In the forex market, all price quotes are represented by two prices, known
as the bid price and the ask price. Both the bid price and ask price represent
the exchange rate of the base currency pair against the quoted pair,
except they serve two different functions. The bid price indicates the price
at which your currency dealer is willing to buy the base currency from you
in exchange for the quoted currency. The ask price indicates the price at
which your currency dealer is willing to sell you the base pair in exchange
for the quoted currency. There is always a difference between the bid price
and the ask price; this difference is known as the spread. The spread isusually less than five pips on major currency pairs. Cross-currency pairs
such as GBP/JPY may have much higher spreads. The spread is the way a
currency dealer earns money for executing a trade.
Figure 1.2 shows the difference between the bid and ask prices offered
in the forex market. The difference between the two prices is known as the
spread.
Using the prices quoted in Figure 1.2, if a trader wanted to buy
EUR/USD, his currency dealer would sell it to him using the ask price of
$1.4002. To sell the position at least at breakeven, the trader needs the bid
price to move up two pips, to $1.4002. Alternatively, if a trader wanted to
sell the EUR/USD, the currency dealer would sell it to him at the bid price
of $1.4000 and the trader would need the market to fall by two pips before
he could sell it at the ask price for a breakeven trade. The two-pip spread
in this EUR/USD example is the cost of doing business with this currency
dealer.