An FX trade can be a little confusing for the newcomer to the world of foreign currency trading but is fairly easy to understand once you break it down into its component parts and learn one or two of the basic trading terms.
The objective in any FX trade is to exchange one currency for another in the belief that the market will move and prices change so that the currency which you have bought will rise in value relative to the currency which you have sold.
A very important point to note here is that every trade involves two currencies – the currency that you buy and the currency that you sell to make the purchase. This principle gives rise to two important trading terms – the long position and the short position.
A trader is said to take a long position when he buys a currency in the expectation that he will able to sell it later at a profit. To realize a profit the trader must of course sell the currency once it has risen in price.
When a trader sells a currency in the expectation that it will fall in value he is said to take a short position and his intention is to buy the currency back again once the price has dropped. The trader will only profit from a fall in the price once he buys the currency back.
As in any pair of currencies a rise in one currency will always be balanced by a fall in the other, it follows that a trader will always be long in one currency and short in the other.
The next important concept is that of the open and closed position. When a trader buys a currency in the expectation that it will rise in value he is said to open a position. When he later sells that currency in order to realize his profit, he closes the position. The same would be true in the case of a trader who opens a position by selling a currency in the expectation that it will fall in price and then closes the position when he buys it back at the lower price.
In foreign exchange trading currencies are referred to by codes (known as ISO codes developed by the International Organization for Standardization) such as USD for the US Dollar and EUR for the Euro. Prices for these two currencies would be quoted as either USD/EUR or EUR/USD with the first currency in the pair being known as the base currency and the second currency being the counter or quote currency. An example will make this a little easier to understand. Let’s look at the following quote:
USD/EUR = 1.3111
Here the US Dollar is the base currency and the Euro is the counter or quote currency. The base currency is always denominated as a single unit and so this quote would mean that it would cost 1.3111 Euros to buy 1 US Dollar. Here’s the other side of the quote:
EUR/USD = 0.7627
In this case it will cost 0.7627 US Dollars to buy 1 Euro.
In actual trading things become a little more complicated because the market maker needs to factor in his profit for selling you a currency or for buying currency from you. As a result the quote might look something like this:
EUR/USD = 0.7625 0.7629
The first figure in the quote is the ‘sell’ or ‘ask’ figure and the second figure is the ‘buy’ or ‘bid’ figure. In other words the first figure is sum at which a trader can sell the currency pair and the second is the price at which he can buy the pair. The difference between the two prices expressed to 4 decimal places is referred to as the spread and in this case is said to be 4 pips. A pip is simply the smallest amount by which one currency can move against another.
So, in our example, if you want to sell Euros, the market maker will pay you 0.7625 US Dollars per Euro and, if you wish to buy Euros, 1 Euro will cost you 0.7629 US Dollars.
As with most things this probably seems a little bit complicated for the beginner but you will soon get the hang of it as this is the very basis on which the FX market operates and will very quickly become second nature.