FX Currency Trading Basics - Part 1

Exchange Rates and Spreads:
All currencies are assigned an International Standards Organization (ISO) code abbreviation. In currency trading, these codes are often used to express which specific currencies make up a currency pair. For example, EUR/USD refers to two currencies: the Euro Dollar and the US Dollar.

EXCHANGE RATE: An exchange rate is simply the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.

EUR/USD
base currency/quote currency

BID/ASK PRICE: A currency exchange rate is typically given as a bid price and an ask price. The bid price is always lower than the ask price. The bid price represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency. The following EUR/USD price quote is an example of bid/ask notation:

EUR/USD: .9726 / .9731

EXAMPLE: The first component (before the slash) refers to the BID price (what you obtain in USD when you sell EUR). In this example, the BID price is .9726. The second component (after the slash) is used to obtain the ASK price (what you have to pay in EUR if you buy USD). In this example, the ASK price is .9731.

SPREAD: The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .05 or 5 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 2nd decimal place (i.e. USD/JPY may be quoted at 119.45/50), in which case 5 pips represents a difference of .05. Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the inter-bank market.

When trading amounts of $1M or higher, the spread obtained in a quote is typically 5 pips. When trading smaller amounts, the spread is typically larger. For example, when trading less than $100,000, spreads of 50-200 pips are common. Credit card companies typically apply a spread of 200-300 pips. Banks and exchange bureaus typically use a spread in the range of 200-1000 pips (in addition to charging a commission). For investors and speculators, a lower or tighter spread translates into easier profit taking due to movements in exchange rates.

Buying and Selling

All trades result in the buying of one currency and the selling of another, simultaneously.

Buying ("going long") the currency pair implies buying the first, base currency and selling an equivalent amount of the second, quote currency (to pay for the base currency). It is not necessary to own the quote currency prior to selling, as it is sold short. A trader buys a currency pair if he/she believes the base currency will go up relative to the quote currency, or equivalently that the corresponding exchange rate will go up.

Selling ("going short") the currency pair implies selling the first, base currency, and buying the second, quote currency. A trader sells a currency pair if he/she believes the base currency will go down relative to the quote currency, or equivalently, that the quote currency will go up relative to the base currency.

An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or lose from fluctuations in the price of that currency pair.

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