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Trading in Forex is very simple, however it is full of abbreviations and simplified procedures due to the necessity to act promptly and make the right
move in the right time. All these abbreviations and simplifications are not always immediately clear to an un-experienced trader, so let's learn
the fundamental concepts of Forex.
Currency pairsThe real goods in Forex are currency pairs and the terms and the procedures are related to them. It's simpler to think about a currency pair instead of the two currencies that compose it. Following the gold rule, buy low and sell high, when you:
The first currency in a currency pair is the "base currency", while the second is the "quote currency". Considering the pair EUR/USD, the EUR is the base currency, while the USD is the quote currency.
When you trade a currency pair, the amount that you trade refers to the base currency, so if you sell 100,000 EUR/USD, you practically sell 100,000 EUR, and if you buy 100,000 EUR/USD, you buy 100,000 EUR. This amount (100,000) is called "face value" in Forex lingo. A trade of 100,000 in face value is known as "standard contract" or a "lot".
While the contract value (face value) is always expressed in the base currency of the pair, the profit or loss value is expressed in the quote currency because the price of the pair is expressed in the quote currency. If you bought the pair EUR/USD at 1.4000, and sold it at 1.4010, you earned 0.0010 USD for each EUR you bought. In other words, you earned 10 pips: in Forex lingo, the smallest measure of price move that a given exchange rate can make is called a PIP.
SpreadEach currency pair has two prices: the bid price and the ask price. Supposing that the pair EUR/USD has rate 1.4000/1.4003, the first value (1.4000) is the Bid price, the price at which the broker buys the currency pair, and that you receive when you sell the pair. The second value (1.4003) is the Ask price (or Offer price), at which the broker sells the pair, and that you pay when you buy the currency pair.
The difference between the Bid and the Ask price, i.e. the spread, is the gain of the broker. If the spread is 3 pips, as from the above example, when you trade 100,000 EUR/USD, the broker will earn 100,000 x 0.0003 = 30 USD, no matter if you make profit or loss.
A lower spread is better for the trader because it makes a higher profit. If the pair goes up by 10 pips (from 1.4000/1.4003 to 1.4010/1.4013), you will earn only 7 pips, because you bought at 1.4003 and you sold at 1.4010.
Leverage and MarginIf you buy a currency pair for an amount that a usual private trader can surely invest, lets say 1,000 USD, and the price increases by 1%, you earn only 10 USD, and your broker will earn only 0.30 USD. It's not a great deal for you, but it's a very bad deal for your broker. He spent the time and must earn his salary.
So the market makers invented a leverage financing: the trader must deposits only a presumed risk of the trade, i.e. margin, and the rest of invested amount will provide the broker. Margin requirement vary from 0.5% to 4%, depends of broker, i.e. the relative leverage (inverse value of the percentage margin) varies from 1:200 to 1:25.
Applying a 1:100 leverage on the example above, your profit, and the broker gain are multiplied by 100: your profit becomes 1,000 USD (100% of your investment), and the broker gain is 30 USD. Be careful with high leverage: the profit is multiplied, but the loss, too. In the same example, if you use 1:100 leverage and the price decreases by 1%, you loss entire invested amount (1,000 USD).