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Components Of Forex Trading

The Forex deal is a contract agreed upon between the trader and market maker. The contract is comprised of following components:

  • The currency pairs
  • The principal amount
  • The rate
  • The Forex deal, in this context, is therefore an obligation to buy and sell a specific amount of a particular pair currency at a pre-determined exchange rate.

Exchange rate

Because currencies are traded in pairs and exchanged one against the other when traded, the rate at which they are exchanged are called exchange rate.

The majority of currencies are traded against the US dollar. The four major currencies traded most frequently after the US dollar is EURO (EUR), JAPANESE YEN (YPY), BRITISH PUND/ GREAT BRITAIN (GBP), SWISS FRANC (CHF). These 5 currencies are traded or have captured most of the volume and so are known as “FAB FIVE”.

The first currency in the exchange pair is referred to as the base currency. The second currency is the counter currency or quote currency. The counter or quote currency is the numerator in the ratio, and the base currency is the denominator.

The exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency.

Example: Exchange rate of EURUSD is 1.3890. This specifies a buyer that 1.3890 USD must be paid to obtain 1 EUR

Spreads

It is the difference between Buy and sell, BID and ASK. In other words, we can say it is the difference between the purchase and the sell price at any given point of time.

Example: EURUSD currency rate is 1.3890-1.3892. Where in 1.3890 is the buy price and 1.3892 is the sell price. In general smaller spreads are better for Forex investors as they require a small movement in exchange rates in order to profit from a trade.

Price, Quote and indications

The price of a currency is called “THE QUOTE”

There are two kinds of quote in the market:

1. DIRECT QUOTE: the price of 1 US dollar in terms of other currency e.g., Japanese yen, Canadian Dollar, etc.

2. INDIRECT QUOTE: the price of 1 unit of currency in terms of US Dollar e.g. British pound, Euro

3. Cross Rates: Any quote which is not against the US Dollar is called “cross”. For example: GBP/JPY is a cross rate

Example of how the GBP/JPY rate is calculated

GBP/USD: 2.0000

USD/JPY: 110.00

SO GBP/JPY IS 2.0000 X 110.00= 220.00

Margin

Banks or other online trading platforms need collateral to ensure that the investor can pay in the event of the loss. The collateral is called the “margin”. And is also known as minimum security in the Forex market. In practice, it is a deposit to a trader’s account that is intended to cover any currency trading losses in the future.

Margin enables private investors to trade in markets that have high minimum units of trading by allowing traders to hold a much larger position than their actual account value. Margin trading also ensures the rate of profit, but similarly enhances the rate of loss, beyond that taken without leveraging.

Most trading platforms require a maintenance margin to be deposited by the trader parallel to the margin deposited for actual trades. The main reason for this is to ensure the necessary amount is available in the event of a ‘gap’ or ‘slippage’ in rates. Maintenance margin is also used to cover administrative costs.

Leveraged financing is a common practice in Forex trading, and allow traders to use credit, such as a trade purchased on margin, to maximize returns. Collateral for the loan/ leverage in the margined account is provided by the initial deposit. This can create an opportunity to control 100,000 USD for as low as 1,000 USD.

Spot transaction

A spot transaction is a straight forward exchange of one currency for another. The spot rate is the current market price, which is called the “benchmark price”. Spot transaction does not require immediate settlement of payment “on the spot”. The two day period provides time to confirm the agreement and to arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.

Risk

Although Forex trading can lead to very profitable results; there are substantial risk involved; exchange rate risk, interest risk, credit risk and event risk.

Approximately 80% of all currency transaction last a period of seven days or less, with more than 40% lasting fewer than 2 days. Given the extremely short life span of the typical trade, technical indicators heavily influence entry, exit and other placement decisions.

PIP

Pip stands for “price interest point” and it represents the smallest fluctuation in price for a given currency pair. For most currencies, the exchange rate is carried out to the fourth decimal place. In this case, a pip is 1/10,000th of the counter currency or .0001

Example: If the ask price in the EUR/USD is 1.1315 and it goes up 1 Pip, the resulting rate will be 1.1316. Some exchange rates like the USD/JPY are only carried out to two decimal points. For these currency pairs, a pip is worth 1/100th of the counter currency

Calculating pip value

Currency PIP Contract Size Contract Size
EUR/USD 0.0001 100000 1.1292
GBP/USD 0.0001 100000 1.6319
USD/JPY 0.01 100000 117.82
USD/CHF 0.0001 100000 1.3736
AUD/USD 0.0001 100000 0.658
  • When USD is the counter currency (EUR/USD), it is easier to calculate the value of one pip and the pip value is static.
  • EUR/USD - 1 Pip=100,000 EUR x .0001 USD/EUR = US $10.00
  • When the USD is the base currency, an extra step must be performed to convert the pip value into dollars. This is done by dividing by the current foreign exchange rate.
  • USD/JPY - 1 Pip= 100,000 USD x .01 JPY/USD= 1,000 JPY/117.82 JPY/USD=US$8.49
  • Again, your broker will usually calculate all this for you, but it's good to know.
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