Welcome to Forex
What is Forex
The foreign exchange market, or forex (FX) for short, is a decentralized market place that facilitates the buying and selling of different currencies. This takes place over the counter (OTC) via the interbank market instead of on a centralized exchange.
Without knowing it, you have probably already participated in the foreign exchange market by ordering imported shoes, or more obviously, buying foreign currency when on vacation. Traders are drawn to forex for several reasons, including:
• The size of the FX market
• A wide variety of currencies to trade
• Differing levels of volatility
• Low transaction costs
• 24 hour a day trading during the week
The Forex Market Explained
In a nutshell, the foreign exchange market works like most other markets in that it is subject to demand and supply. Using a very basic example, if there is a strong demand for the US Dollar from European citizens holding Euros, they will exchange their Euros into Dollars. The value of the US Dollar will rise while the value of the Euro will fall. Keep in mind that this transaction only affects the EUR/USD currency pair and will not for example, cause the USD to depreciate against the Japanese Yen.
What Moves the Forex Market
In reality, the above example is only one of many factors that can move the FX market. Others include broad macro-economic events like the election of a new president, or country specific factors such as the prevailing interest rate, GDP, unemployment, inflation and the debt to GDP ratio, to name a few. Top traders make use of an economic calendar to stay up to date with these and other important economic releases that can move the market.
What Makes Forex so Attractive
The foreign exchange market allows large institutions, governments, retail traders and private individuals to exchange one currency for another and takes place via the interbank market (between banks).
The benefit of having forex trade between global banks is that forex can be traded around the clock (during the week). As the trading session in Asia comes to a close, the European and UK banks come online before handing over to the US. The full trading day ends when the US session leads into the Asian session for the following day.
What makes this market even more attractive to traders is that it is by far the most liquid market in the world, with an average daily trading volume of $5.1 trillion according to BIS Triennial Survey 2016. This means that traders can easily enter and exit positions as there are many willing buyers and sellers for foreign exchange.
What is forex trading and how does it work
Many people wonder how to make money trading forex. Fortunately, the basics behind forex trading are quite straight forward. If you think the value of a currency is going to go up (appreciate), you buy the currency. This is known as going “long”. If you feel the currency is going to go down (depreciate), you sell that currency. This is known as going “short”.
Who Trades Forex
There are essentially two types of traders in the foreign exchange market: hedgers and speculators. Hedgers are always looking to avoid extreme movements in the exchange rate. Think of big conglomerates like Exxon and how they look to reduce their exposure to foreign currency movements.
Speculators, on the other hand, are risk seeking and always looking for volatility in exchange rates to take advantage of. These include large trading desks at the big banks and retail traders.
Reading a Forex Quote
All traders need to understand how to read a forex quote as this is will determine the price you enter and exit the trade. Looking at the currency quote below, the first currency in the EUR/USD pair is known as the base currency, which is the Euro, while the second currency in this pair (the USD) is known as the variable or quote currency.
For most FX markets, prices are offered up to five decimals but the first four are the most important. The number to the left of the decimal point indicates one unit of the variable currency, in this example, it is the USD and therefore is $1. The following two digits are the cents, so in this case 13 US cents. The third and fourth digits represent fractions of a cent and are referred to as pips.
It’s key to note that the number in the fourth decimal place is known as a ‘pip’. Should the EUR depreciate against the USD by 100 pips, the new sell price will reflect the lower price of 1.12528 as it will cost less in USD to buy 1 Euro.
Why trade forex
Trading forex has many advantages over other markets as explained below:
1. Low transaction costs: Typically, forex brokers make their money on the spread provided the trade is opened and closed before any overnight funding charges are applied. Therefore, forex trading is cost effective when weighed up against a market like equities, which attracts a commission charge.
2. Low spreads: Bid/Ask spreads are extremely low for major FX pairs due to their liquidity. When trading, the spread is the initial hurdle that needs to be overcome when the market moves in your favor. Any additional pips that move in your favor is pure profit.
3. More opportunities to profit: Forex trading allows traders to take speculative positions on currencies going up (appreciating) and going down (depreciating). Furthermore, there are many different forex pairs for traders to spot profitable trades.
4. Leverage trading: Trading forex involves the use of leverage. This means that a trader need not pay the full cost of the trade but instead only put down a fraction of the cost. This has the potential to magnify your profits but also your losses. At BMEC we suggest a disciplined approach to risk management by restricting your effective leverage to 10 to one or less.
Key forex trading terms to takeaway
Base currency: This is the first currency that appears when quoting a currency pair. Looking at EUR/USD, the Euro is the base currency.
Variable/quote currency: This is the second currency in the quoted currency pair and is the US Dollar in the EUR/USD example.
Bid: The bid price is the highest price that a buyer (bidder) is prepared to pay. When you are looking to sell a forex pair this is the price you will see, usually to the left of the quote and is often in red.
Ask: This is the opposite of the bid and represents the lowest price a seller is willing to accept. When you are looking to buy a currency pair, this is the price you will see and is usually to the right and in blue.
Spread: This is the difference between the bid and the ask price which represents the actual spread in the underlying forex market plus the additional spread added by the broker.
Pips/points: A pip or point refers to a one digit move in the 4th decimal place. This is often how traders refer to movements in a currency pair, i.e. GBP/USD rallied 100 points today.
Leverage: Leverage allows traders to trade positions while only putting up a fraction of the full value of the trade. This allows traders to control larger positions with a small amount of capital. Leverage amplifies gains AND losses.
Margin: This is the amount of money needed to open a leveraged position and is the difference between the full value of your position and the funds being lent to you by the broker.
Margin call: When the total capital deposited, plus or minus any profits or losses, dips below a specified level (margin requirement).
Liquidity: A currency pair is considered to be liquid if it can easily be bought and sold due to there being many participants trading the currency pair.
What are we trading
“…When money flows into a currency, it strengthens, and when money flows out of a currency, it weakens.”
When we place a trade in the forex market, we are buying one currency and selling the other. This is why forex is traded in currency “pairs.” As a visual example, we can reference the image below.
If we buy a currency pair, like the EUR/USD, we are buying euros and selling dollars. We place this trade when we believe the EUR/USD exchange rate will rise and allow us to sell back our euros for a larger amount of dollars at some point in the future.
But in the forex market, we can trade the other direction as well. So we could sell the EUR/USD, effectively selling euros and buying dollars. With that trade, we would want the EUR/USD exchange rate to fall so we can buy back the euros for less dollars than we originally sold them for.
So not only do we have a goal of buying low and later selling high, we have the option to sell high first, and then buy low later. There are no restrictions on short selling and we do not need to own any euros prior to selling the EUR/USD. This is what people refer to as a “two-way market.”
What is a pip
What are pips in forex trading
“PIP” – which stands for Point in Percentage - is the unit of measure used by forex traders to define the smallest change in value between two currencies. This is represented by a single digit move in the fourth decimal place in a typical forex quote.
For example, if the price of EUR/USD moves from 1.1402 to 1.1403 this would be a one pip or ‘point’ movement. Example of a pip using the quote to buy EUR/USD
However, not all forex quotes are displayed in this way, with the Japanese Yen being the notable exception. Keep reading to find out more about pips and how they’re used in forex trading, with examples from selected major currency pairs.
How to calculate the value of a pip
The pip value is calculated by multiplying one pip (0.0001) by the specific lot/contract size. For standard lots this entails 100,000 units of the base currency and for mini lots, this is 10,000 units. For example, looking at EUR/USD, a one pip movement in a standard contract is equal to $10 (0.0001 x 100 000).
Being able to calculate the value of a single pip helps forex traders put a monetary value to their take profit targets and stop loss levels. Instead of simply analysing movements in pips, traders can determine how the value of their trading account (equity) will fluctuate as the currency market moves.
It’s important to note that the value of one pip will differ for different currency pairs. This is because the value of one pip will always be shown in the currency of the quote/variable currency and this will differ when trading different currency pairs. When trading EUR/USD, the value of one pip will be displayed in USD, when trading GBP/JPY, this will be in JPY.
Calculating the value of one pip - EUR/USD pips example
As each currency has its own relative value, it’s necessary to calculate the value of a pip for each particular currency pair.
Keep in mind that forex trading involves set amounts of currency that you can trade. Most brokers offer a standard and a mini contract with the specifications in the table below:
|TYPE OF CONTRACT CONTRACT SIZE (NO. OF UNITS OF THE BASE CURRENCY)|
|Standard Lot||100 000|
|Mini Lot||10 000|
The value of one pip for the EUR/USDstandard contract is calculated as follows:
|Pip Value =||Contract Size × One Pip|
|Pip Value =||100 000 × 0.0001|
|Pip Value =||$10|
Every one pip move in your favor translates into a $10 profit and every one pip move that goes against you translates into a $10 loss. By the same logic, a one pip move in a mini contract translates into a $1 profit or loss (10,000 x 0.0001).
To help understand pips and pip calculations even further you may want to consider doing some practice calculations on your own.
Pip Value Conversions
Now, if your account is based in Great British Pounds (GBP), you would have to convert that $1 (value of a pip for a 10k EUR/USD lot) into Pounds. To do so, just divide the $1 by the current GBP/USD exchange rate, which at the time of writing is 1.2863. It is necessary to divide here because a Pound is worth more than a US dollar, so I know my answer should be less than 1. 1 divided by 1.2863 is 0.7774 Pounds. So now you know that if you have a Pound based account, and profit or lose one pip on one 10k lot of EUR/USD, you will earn or lose 0.7774 Pounds.
The exception - USD/JPY pips
When trading major currencies against the Japanese Yen, traders need to know that a pip is no longer the fourth decimal but rather the second decimal. This is because the Japanese Yen has a much lower value than the major currencies.
Looking at the USD/JPY quote below, the ask (buy) price is as much as 107.99 Yen for 1 USD.
When trading the mini contracts (10k) and standard contracts (100k) in Japanese Yen, a one pip movement (the value of one pip) will be JPY100 and JPY1000, respectively.
The History of Forex
Forex trading, which is the act of exchanging fiat currencies, is thought to be centuries old – dating back to the Babylonian period. Today, the forex market is one of the biggest, most liquid and accessible markets in the world, and has been shaped by several important global events, like Bretton woods and the gold standard.
It’s important for forex traders to understand the history of forex trading, and the key historic events which have shaped the market. This is because similar events could likely occur again in different, but similar forms – impacting the trading landscape. History tends to repeat itself.
History of Forex Trading: Where it all began
The barter system is the oldest method of exchange and began in 6000BC, introduced by Mesopotamia tribes. Under the barter system goods were exchanged for other goods. The system then evolved and goods like salt and spices became popular mediums of exchange. Ships would sail to barter for these goods in the first ever form of foreign exchange. Eventually, as early as 6th century BC, the first gold coins were produced, and they acted as a currency because they had the critical characteristics like portability, durability, divisibility, uniformity, limited supply and acceptability.
Gold coins became widely accepted as a medium of exchange, but they were impractical because they were heavy. In the 1800s countries adopted the gold standard. The gold standard guaranteed that the government would redeem any amount of paper money for its value in gold. This worked fine until World War I where European countries had to suspend the gold standard to print more money to pay for the war.
The foreign exchange market was backed by the gold standard at this point and during the early 1900s. Countries traded with each other because they could convert the currencies they received into gold. The gold standard, however, could not hold up during the world wars.
Key events which have shaped the forex market
Throughout history, we have seen major events that have greatly influenced the forex trading environment. Here are some highlights:
The Bretton Woods System 1944 – 1971
The first major transformation of the foreign exchange market, the Bretton Woods System, occurred toward the end of World War II. The United States, Great Britain, and France met at the United Nations Monetary and Financial Conference in Bretton Woods, NH to design a new global economic order. The location was chosen because at the time, the US was the only country unscathed by war. Most of the major European countries were in shambles. In fact, WWII vaulted the US dollar from a failed currency after the stock market crash of 1929 to benchmark currency by which most other international currencies were compared.
The Bretton Woods Accord was established to create a stable environment by which global economies could restore themselves. It attempted this by creating an adjustable pegged foreign exchange market. An adjustable pegged exchange rate is an exchange rate policy whereby a currency is fixed to another currency. In this case, foreign countries would 'fix' their exchange rate to the US Dollar. The US dollar was being pegged to gold, because the US held the most gold reserves in the world at that time. So foreign countries would transact in the US Dollar (this is also how the US dollar became the world’s reserve currency).
The Bretton Woods agreement eventually failed to peg gold to the US dollar because there was not enough gold to back the amount of US Dollars in circulation, because the amount of US Dollars in circulation increased due to increased government lending and spending. In 1971, President Richard M. Nixon, ended the Bretton Woods system which soon led to the free floating of the US Dollar against other foreign currencies.
The Plaza Accord
In the early 1980s the dollar had appreciated greatly against the other major currencies. This was hard on exporters and the US current account subsequently ran a deficit of 3.5% of GDP. In response to stagflation that began in the early 1980s, Paul Volcker raised interest rates which caused a strong US Dollar (and decreased inflation) at the expense of the US industry’s competitiveness in the global market.
The weight of the US dollar was crushing third-world nations under debt and closing American factories because they could not compete with foreign competitors. In 1985, the G-5, the most powerful economies in the world – US, Great Britain, France, West Germany, and Japan – sent representatives to what was supposed to be a secret meeting at the Plaza Hotel in New York City. News of the meeting leaked, forcing the G-5 to make a statement encouraging the appreciation of non-dollar currencies. This became known as the “Plaza Accord” and its reverberations caused a precipitous fall in the dollar.
It did not take long for traders to realize the potential for profit in this new world of currency trading. Even with government intervention, there still were strong degrees of fluctuation and where there is fluctuation, there is profit. This became clear a little over a decade after the collapse of Bretton Woods.
The Beginning of the Free-Floating System
After the Bretton Woods Accord came the Smithsonian Agreement in December of 1971, which was similar but allowed fora greater fluctuation band for the currencies. The United States pegged the dollar to gold at $38/ounce, thereby depreciating the dollar. Under the Smithsonian agreement, other major currencies could fluctuate by 2.25% against the US Dollar, and the US Dollar was pegged to gold.
In 1972, the European community tried to move away from its dependency on the US Dollar. The European Joint Float was then established by West Germany, France, Italy, the Netherlands, Belgium, and Luxemburg. Both agreements made mistakes like the Bretton Woods Accord and in 1973 collapsed. These failures resulted in an official switch to the free-floating system.
Establishment of the Euro
After WWII, Europe forged many treaties designed to bring countries of the region closer together. None were more prolific than the 1992 treaty referred to as the Maastricht Treaty, named for the Dutch city where the conference was held. The treaty established the European Union (EU), led to the creation of the Euro currency, and put together a cohesive whole that included initiatives on foreign policy and security. The treaty has been amended several times, but the formation of the Euro gave European banks and businesses the distinct benefit of removing exchange risk in an ever-globalized economy.
In the 1990s, the currency markets grew more sophisticated and faster than ever because money – and how people viewed and used it – was changing. A person sitting alone at home could find, with the click of a button, an accurate price that only a few years prior would have required an army of traders, brokers, and telephones. These advances in communication came during a time when former divisions gave way to capitalism and globalization (the fall of the Berlin Wall and the Soviet Union).
For forex, everything changed. Currencies that were previously shut off in totalitarian political systems could be traded. Emerging markets, such as those in Southeast Asia, flourished, attracting capital and currency speculation.
The history of forex markets since 1944 presents a classic example of a free market in action. Competitive forces have created a marketplace with unparalleled liquidity. Spreads have fallen dramatically with increased online competition among trustworthy participants. Individuals trading large amounts now have access to the same electronic communications networks used by international banks and merchants.
Interest Rate expectations
There’s a strong correlation between interest rates and forex trading. Forex is ruled by many variables, but the interest rate of the currency is the fundamental factor that prevails above them all.
Simply put, money attempts to follow the currency with the highest real interest rate. The real interest rate is the nominal interest rate less inflation.
Forex traders must keep an eye on each country’s central bank interest rate and more importantly, when it is expected to change, to forecast moves in currencies.
What are interest rates and why do they matter to forex traders
When traders talk about ‘interest rates’ they are usually referring to central bank interest rates. Interest rates are of utmost importance to forex traders because when the expected rate of interest rates change, the currency generally follows with it. The central bank has several monetary policy tools it can use to influence the interest rate. The most common being:
• Open market operations: The purchase and sale of securities in the market with the goal of influencing interest rates.
• The discount rate: The rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility.
Central banks have two main tasks: to manage inflation and promote stability for their country’s exchange rate. They do this by changing interest rates and managing the nation’s money supply. When inflation is ticking upwards, above the central bank’s target, they will increase the central bank rate (using the policy tools) which can restrict the economy and bring inflation back in check.
The economic cycle and interest rates
Economies are either expanding or contracting. When economies are expanding, everyone is better off, and when economies are contracting (recession) they are worse off. The central bank aims to keep inflation in check while allowing the economy to grow at a modest pace, all by managing the interest rate.
When economies are expanding (GDP Growth positive), consumers start to earn more. More earning leads to more spending, which leads to more money chasing fewer goods – triggering inflation. If inflation is left unchecked it can be disastrous, so the central bank attempts to keep inflation at its target level, which is 2% (for most central banks), by increasing interest rates. Increased interest rates make borrowing costlier and helps reduce spending and inflation.
If the economy is contracting (GDP growth negative), deflation (negative inflation) becomes a problem. The central bank lowers interest rates to spur spending and investment. Companies start to loan money at low interest rates to invest in projects, which increases employment, growth, and ultimately inflation.
The cycle goes something like this:
How do interest rates affect currencies
The way interest rates impact the forex markets is through a change in expectations of interest rates that lead to a change in demand for the currency. The table below displays the possible scenarios that come from a change in interest rate expectations:
|MARKET EXPECTATIONS ACTUAL RESULTS RESULTING FX IMPACT|
|Rete Hike||Rate Hold||Depreciation of currency|
|Rate Cut||Rate Hold||Appreciation of currency|
|Rate Hold||Rete Hike||Appreciation of currency|
|Rate Hold||Rate Cut||Depreciation of currency|
Interest rate relevance to forex trading
Imagine you are an investor in the UK that needs to invest a large sum of money in a risk-free asset, like a government bond. Interest rates in the US are on the rise so you start to buy US Dollars to invest in the US government bonds.
You (being the UK investor) are not alone in investing in the country with higher interest rates. Many other investors follow the increase in yield and so increase the demand for US Dollars which appreciates the currency. This is the essence of how interest rates affect currencies. Traders can attempt to forecast changes in expectations of the interest rate which can have a large effect on the currency.
Here is an example of what happens when the market expects the central bank to keep interest rates on hold, but then central bank decreases the interest rate. In this example, the Reserve Bank of Australia was expected to keep interest rates on hold at 4% but instead hiked it to 4.25%. The market was surprised by the rate cut so the AUD/USD depreciated.
Understanding forex interest rate differentials
Interest rate differentials are simply differences in interest rates between two countries.
If a trader expects the US to unexpectedly hike interest rates he/she anticipates the US dollar may appreciate. To increase the trader’s chances of success, the trader can buy the US Dollar against a currency with low interest rates as the two currencies are diverging in the direction of their respective interest rates.
Interest rates and their differentials have a large influence on the appreciation/depreciation of the currency pair. The changes in interest rate differentials are correlated to the appreciation/depreciation of the currency pair. It is easier to understand visually. The chart below compares the AUD/USD currency pair (candlestick graph) and the difference between the two-year AUD government bonds and the two-year USD government bonds (orange graph). The relationship shows that as the AUD bonds yield decreases relative to the USD bonds, so does the currency.
Interest rate differentials are widely used in carry trades. In a carry trade money is loaned from a country with a low rate and invested in a country with a higher interest rate. There are, however, risks involved with the carry trade such as the currency invested in depreciating relative to the currency used for funding the trade.
How to forecast central bank rates and the impact on FX markets
Fed funds futures are contracts traded on the Chicago Mercantile Exchange (CME) that represent the markets expectations of where the daily official federal funds rate will be when the contract expires. The market always has its own forecast of where the interest rate will be. A trader’s job is to forecast a change in those expectations.
For a trader to forecast central bank rates he/she will need to keep a close eye on what the central bankers are currently monitoring. Central bankers try to be as transparent as possible to the public about when they expect to increase interest rates and which economic data they are currently monitoring.
The central bankers decide to increase or decrease interest rates based on several economic data points. You can keep up to date with the release of these data points using an economic calendar. Inflation, unemployment, and the exchange rate are some of the major data points. The trader must be in tune with the central bank policy makers and almost try to forecast what their actions will be before they state it to the public. This way the trader can reap the benefits of the markets change in expectations. This method of trading is based on the fundamentals which is different to trading using technical analysis.
Forex interest rate trading strategies
Forex traders can opt to trade the result of the interest rate news release, buying or selling the currency the moment the news releases. See our guide on trading the news for more expert information.
Advanced forex traders may attempt to forecast changes in central banker’s tones, which can shift market expectations. Traders will do this by monitoring key economic variables like inflation, and trade before central banker’s speeches.
Another method is to wait for a pullback on the currency pair after the interest rate result. If the central bank unexpectedly hiked rates, the currency should appreciate, a trader could wait for the currency to depreciate before executing a buy position- anticipating that the currency will continue to appreciate.
1. The interest rate decisions themselves tend to be less important than the expectations for future interest moves.
2. Trading currencies with increased interest rate differentials could increase the probability of successful trades.
3. It is important to keep up to date with economic data using an economic calendar to forecast potential changes in market expectations.
Forex Market Size
The size and depth of the forex market make it an ideal trading market. Its liquidity makes it easy for traders to sell and buy currencies without delay. This creates tight spreads for favorable quotes. Low costs, large scope to various markets and flexible trading times make it the most frequently traded market in the world. This article will clarify the enormity of the forex market, which allows for a better understanding of the mechanics behind it on a macro scale. Ultimately providing a solid foundation to forex trading for beginners through to the advanced trader.
How big is the forex market and how much is it worth
According to the Bank for International Settlements triennial report of 2016, the foreign exchange market cap averaged $5.1 trillion per day. This figure is down from the previous report in 2013 of $5.4 trillion. There are only a few countries that account for the majority of forex trading turnover. The graph below depicts the major global trading desks as a percentage of total average turnover.
From a trader’s perspective, large forex market capitalization lends to less volatility as large trades do not have as significant impact on the price of the market. Smaller markets can be influenced by large institutions/traders with relative ease, however within the forex market this impact is comparatively diluted.
The forex market is comprised of several key constituents. The most influential being banks. The interbank market encompasses the largest volume of foreign exchange trading within the currency space. This includes trading between banks, trades for clients and facilitated trading by their individual desks. The US banks control the majority share of this market. Central banks, investment managers, hedge funds, corporations and lastly retail traders round off the rest of the market. Roughly 90% of this volume is generated by currency speculators capitalizing on intraday price movements.
As retail traders, it is essential to comprehend the enormity of the forex market in to be successful in your trading strategy, as well as how these different components interact with each other on a larger scale.
Forex trading volume
Traders from other markets are attracted to forex because of its extremely high level of liquidity. Liquidity is important as it allows traders to get in and out of a position at with ease 24 hours a day, five and a half days a week. It allows large trading volumes to enter and exit the market without the large fluctuations in price that would happen in less liquid market. This means that if you will never get in a position because of the lack of a buyer. This liquidity can vary from one trading session to another and one currency pair to another as well.
As the most traded currency pairs, EUR/USD and USD/JPY account for approximately 41% of all forex trades annually. This is an astounding percentage considering the scale of the overall forex market size. Another surprising fact is that most of the pairs reflective in the diagram below are USD crosses.
The US Dollar makes up 85% of forex trading volume. At nearly 40% of trading volume, the Euro is ahead of the third-place Japanese Yen that takes almost 20%. With volume concentrated mainly in the US Dollar, Euro and Yen, forex traders can focus their attention on just a handful of major pairs. In addition, the greater liquidity found in the forex market is conducive to long, well-defined trends that respond well to technical analysis and charting methods.
How to take advantage of the forex market
Traders keen to capitalize on the advantages that come with the sheer size and volume of the forex market need to consider what method or combination of analysis suits their trading style. At a foundational level, traders need to understand the following pillars to forex trading:
• Fundamental Analysis: Since currencies trade in a market, you can look at supply and demand. This is called fundamental analysis. Interest rates, economic growth, employment, inflation, and political risk are all factors that can affect supply and demand for currencies.
• Technical Analysis: Price charts tell many stories and most forex traders depend on them in making their trading decisions. Charts can point out trends and important price points where traders can enter or exit the market, if you know how to read them.
• Money Management: An essential part of trading. All traders need to know how to measure their potential risks and rewards and use this to judge entries, exits, and trade size. Forex traders employ these pillars in varying forms to craft a strategy they feel comfortable with.
Once they find a balance between these central systems, they will turn their attention to specializing and honing their skills by keeping up to date with politics, monetary/fiscal policies etc. and making informed decisions based on the information at hand. A technical trader may utilize various indicators/drawings and place trades resulting from these technical signals. Client sentiment can also give forex traders an inside scoop as to potential reversals, market entry and exit points.
Forex Quotes Explained
Forex quotes reflect the price of different currencies at any point in time. Since a trader’s profit or loss is determined by movements in price (the quote), it is essential to develop a sound understanding of how to read currency pairs.
What are forex quotes
A forex quote is the price of one currency in terms of another currency. These quotes always involve currency pairs because you are buying one currency by selling another. For example, the price of one Euro may cost $1.1404 when viewing the EUR/USD currency pair. Brokers will typically quote two prices for any currency pair and receive the difference (spread) between the two prices, under normal market conditions.
Example of EUR/USD forex quote：
Understanding Forex Quote Basics
In order to read currency pairs correctly, traders should be aware of the following fundamentals of a forex quote:
ISO code: The International Organization for Standardization (ISO) develop and publish international standards and have applied this to global currencies. This means each country’s currency is abbreviated to three letters. For example, the Euro is shortened to EUR and the US dollar to USD.
Base currency and variable currency: Forex quotes show two currencies, the base currency, which appears first and the quote or variable currency, which appears last. The price of the first currency is always reflected in units of the second currency. Sticking with the earlier EUR/USD example, it is clear to see that one Euro will cost one dollar, 14 cents and 04 pips. This is unusual as you cannot physically hold fractions of one cent but this is a common feature of the foreign exchange market.
Bid and ask price
When trading forex, a currency pair will always quote two different prices as shown below:
The bid(SELL) price is the price that traders can sell currency at, and the ask(BUY) price is the price that traders can buy currency at. This may seem confusing as it is only natural to think of “bid” in terms of buying so just remember the bid/ask terminology is from the broker’s perspective.
Traders will always be looking to buy forex when the price is low and sell when the price rises; or sell forex in anticipation that the currency will depreciate and buy it back at a lower price in the future.
The price to buy a currency will typically be more than the price to sell the currency. This difference is called the spread and is where the broker earns money for executing the trade. Spreads tend to be tighter (less) for major currency pairs due to their high trading volume and liquidity. The EUR/USD is the most widely traded currency pair, so it is no surprise that the spread in this example is 0.6 pips.
Direct vs Indirect Quotes
Quotes are often displayed in accordance with the “home currency” in mind i.e. the country you reside in. A direct quote for traders in the US, looking to buy Euros, will read EUR/USD and will be relevant to US citizens as the quote is in USD. This direct quote will provide US citizens with the price of one Euro, in terms of their home currency which is 1.1404.
The indirect quote is essentially the inverse of the direct currency (1/direct quote = 0.8769). It shows the value of one unit of domestic currency in terms of foreign currency. Indirect quotes can be useful to convert foreign currency purchases abroad into domestic currency.
Top tips to read forex quotes
1. Bid and Ask prices are from the perspective of the broker. Traders buy currency at the ask price and sell at the bid price.
2. The base currency is the first currency in the pair and that the quote currency is the second currency.
3. The smallest movement for non-JPY currency pairs is one pip (a single digit movement in the fourth decimal place of the quoted price and a single digit movement in the second decimal place for JPY pairs).
4. The spread is the initial hurdle (cost) that traders realize in a trade.
Understanding The Forex Majors
By now you probably know that foreign exchange rates are quoted in pairs. While this is important, it is also imperative to know exactly which currencies are being referenced in these pairs. Whether you are preparing to place your first trade or are a seasoned pro analyzing extensive research having a firm grasp on which currency is which will ultimately influence your decisions.
When trading Forex, it is inevitable that traders will run across currencies known as “The Majors”. This term is in reference to the most frequently traded currencies in the world, with the list normally including the Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Great British Pound (GBP), Australian Dollar (AUD), and Swiss Franc (CHF).See the graph below, and you will find a list of the Major currencies along with their associated country and ISO symbol.
The Symbol is how you will know exactly which currency you are trading when referencing a Forex Bid/Ask quote. However, it is also important to review each currencies nickname. These names will often come up in research and will be handy when communicating with other Forex traders.
Major Currency Pairs
Next we will take a look at currencies pairs that are considered “Major Pairs”. The Major Pairs are a reference to any of the major currencies listed above when paired with the USD. For example, the EURO is considered a major currency, but when paired with the USD (EUR/USD) the quote becomes a reference to a major pair.
Forex Spreads Trading Strategies & Tips
Beware a widening spread
Traders should always be aware of the spread because it is the primary cost involved in forex trading. A wider spread will lead to a larger trading cost.
Times of volatility or illiquid currency pairs accompanied with leverage could signal the end for a forex trader. Keep in mind that the more leverage used the higher the spread cost will be compared to your accounts equity, so it is beneficial to use little or no leverage.
Beginner traders should be especially wary of the spread. If you have a small account size and you take a slightly large position, relative to your account size, the spread could widen, and you may receive a margin call, or your position could even be closed.
The following three spread trading techniques and strategies are a great way to learn the basics to ensure your FX trading is a success: Keeping an eye on factors that influence the spread, the liquidity of the currency pair and the time of day.
1) Keep an eye on factors which affect the size of the spread
To avoid large spread costs associated with a widening spread, traders should be aware of the following factors:
• Volatility: Volatility in the market brought about by economic data releases or a breaking news event could trigger a spread to widen.
• Liquidity: A lack of liquidity in the market could also cause a spread to widen. Liquidity and volatility are two interconnected concepts. Illiquid currency pairs, such as emerging market currencies, are known for their high spreads. Illiquid markets can also be a cause of volatility.
• Spreads and the news: Before a popular news event, like the NFP employment number release, liquidity providers may widen their spreads to offset some of their risk caused by the event.
Usually the spread will revert to its mean after a few minutes, so it is advisable for traders to be patient and only trade when the spread narrows.
2) Choose high liquidity forex pairs
Another forex spread trading strategy many traders – particularly beginners – adopt is choosing high liquidity forex pairs. Under normal circumstances, high liquidity pairs have lower spreads.
Your major currency pairs, the EUR/USD (Euro Dollar), USD/JPY (Dollar Yen), GBP/USD (Pound Dollar), USD/CHF (Dollar Swiss Franc), will have the lowest spread amongst all currency pairs because they trade in high volumes.
These currencies do not always trade at low spreads and because they are affected by volatility, liquidity and the news which can lead to widening spreads.
Emerging market currencies like the USD/MXN (US dollar/Mexican Peso), USD/ZAR (US Dollar/South African Rand) or the USD/RUB (US Dollar/Russian Ruble), generally have higher spreads compared to your major currency pairs. Therefore, it is wise for traders to trade these pairs with less leverage, or no leverage at all.
In the image below, the black boxes show the spread of the certain currencies. The major market currency pairs, the USD/JPY and EUR/USD display narrow spreads- 0.7 pips and 0.6 pips respectively.
The emerging market currencies, the USD/ZAR and USD/RUB on the other hand, have extremely wide spreads 90 pips and 1000 pips respectively.
3) Time of day trading
The time of day influences forex spreads, so it can be useful factoring this in to your strategy. During your major market trading sessions - London, New York, Sydney and Tokyo - forex spreads are normally at their lowest due to the high volume being traded.
Forex traders could trade during these times to take advantage of narrower spreads. When the London and New York sessions overlap, spreads can become even narrower.
The hours shown below are Eastern Time. Between 8am and 11pm Eastern time the London and New York session overlap.
There are other factors that influence when it could be the best time of day to trade forex.
Forex spread trading example using USD/JPY
If you combine all the above spread trading techniques, you can reduce the risk of trading at a high spread. It is important to remember these steps when executing a trade and when closing a trade because the spread may change from when you open the position to when you want to close it.
Let’s look at a simple example using the USD/JPY, which is among the major currency pairs – meaning it has high liquidity and therefore very low spreads compared to other forex pairs.
Keep an eye on factors that may affect the spread
If we were to trade the USD/JPY, we need to make sure there are no shock-events or data releases that could affect the spread. You can do this by keeping up to date with the latest news and using an economic calendar.
A sample from the economic calendar is below. Events with a ‘high impact’ have a higher chance of increasing the spread, so unless you are trading the news event, it is wise to trade around these events.
Some events that could increase volatility, and the spread include:
• GDP releases
• CPI (inflation data)
• NFP (non-farm payrolls)
Consider time of day trading
We also need to consider when to trade the USD/JPY, the USD/JPY has a lot of volatility. One of the most liquid times to trade forex in generally is between 8am and 11am eastern time, when the London and New York session overlap. The USD/JPY also is highly liquid during the Tokyo session.
Emerging market currencies can see extremely large spreads they trade out of their main market sessions. When trading emerging market currencies you should plan to trade them during their main market hours when they are most liquid.