Lesson 4: Forex Terms and Definitions
Just like any other industry, Forex market is packed with specific terminology that can be confusing to beginners. However, most of it isn’t as complicated as it may seem, so you will easily find yourself reading professional Forex articles in a little while.
Standing for “Percentage in Point”, pip is the measurement of the change in value. A pip is usually the last decimal point of a quotation, for example if EUR/USD changes from 1.1153 to 1.1154 the 0.0001 USD rise in value is one pip. For the most of currency pairs, pip is the fourth decimal point. For pairs with Japanese Yen, however, the pip is the second decimal point. A change in USD/JPY from 120.97 to 120.98 is a change in price of one pip. Generally, the currency pairs tend to be quoted to five decimal places and JPY pairs to 3 decimal places. The fifth (or 3rd for JPY pairs) decimal is called fractional pip. For example, if GBP/JPY moves from 188.332 to 188.331 this is a 0.001 JPY move or one fractional pip.
A lot refers to a bundle of units in trade. Basically, lot is the size of a trade. There are four commonly known lot sizes:
- Standard lot: 100,000 units of the quote currency in a forex trade.
- Mini lot: 10,000 units of the quote currency
- Micro lot: 1,000 units of the quote currency
- Nano lot: 100 units of the quote currency
For example, if a trader sells 100,000 USD, then he/she sells a standard lot with a trade size of 100,000 units. One standard lot is also known as one contract size.
In electronic forex trading, leverage lets you trade a bigger amount than your deposit. In a way, it’s similar to borrowing from a bank. You give a deposit to the bank, let’s say USD 1,000 for example, and the bank lends you USD 10,000. The leverage amount depends on the trader choices and what a broker offers. The leverage could be from 1:1 (no leverage basically) to 1:500. For example, a leverage of 1:100 means that the trader has an account margin of USD 1,000 and is able to open a position up to USD 100,000! That’s quite interesting eh? It is important to note that leverage may results to unlimited potential gains but the potential losses do not exceed a trader’s invested capital.
As mentioned above, margin is the amount of money needed to open and maintain a position while free margin is the amount of funds that is available to open additional positions.
Bid vs Ask
Forex traders have 2 prices for every pair on their trading platform. The bid and the ask price. Bid is the price the broker is willing to buy the base currency in exchange for the quote currency, thus the price that the trader would sell the currency pair.
Ask or offer is the price the broker asks to sell the base currency (and thus buy the quote currency). Thus, the ask price is the best available price at which the trader will buy from the market
Spread is simply the difference between the bid and the ask price.
On the EUR/USD example above, the bid price is 1.10288 and the ask price is 1.10298. If a trader wants to buy EUR/USD though this broker, he/she would click on the ask price, the price at which the broker is willing to sell.
Long vs Short
In forex, “going long” refers to buying, which actually means to buy the base currency and sell the quote currency. Thus if a trader wants to buy a currency, he wants the base currency to rise in value and then sell it back at a higher price. That’s a “going long” or taking a “long position”.
If a trader wishes to sell, which actually means to sell the base currency and buy the quote currency, he/she wants the base currency to fall in value and then buy it back at a lower price. This is called “going short” or taking a “short position”.
The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. For example, in the case of the EUR/USD rate of 1.1433/36, the transaction cost is 3 pips. The formula for calculating the transaction cost is:
Transaction cost (spread) = Ask Price – Bid Price