Think Forex Trading is Confusing? Here's What You Need to Know
Forex Market Basics
"Forex" stands for Foreign Exchange, and refers to the buying or selling of one currency for another. It's the most heavily traded market in the world because people, businesses, and countries all participate in it. When you go on a trip and convert your US dollars for euros, you're participating in the global foreign exchange market. How much demand there is for a currency will either push it up or down in value relative to other currencies. With this in mind, here's some things you need to know about the currency market, so you can take the next step and start forex trading.
- In the Forex market, currencies always trade in pairs. When you exchange US dollars for euros, there are two currencies involved. For every foreign exchange transaction, you must exchange one currencyfor another. This is why the forex market uses currency pairs, so you can see the cost of one currency relative to another. The EUR/USD price, for example, lets you know how many US dollars (USD) it takes to buy one euro (EUR).
- The Forex market uses symbols for currencies. The euro is symbolized by EUR, the US dollar is the USD. Other currency symbols are: Australian dollar=AUD, British pound=GBP, Swiss franc=CHF, Canadian dollar=CAD, New Zealand dollar=NZD and Japanese yen=JPY.
- Each forex pair, EUR/USD, AUD/USD, USD/JPY for example, will have a market price associated with it. The price refers to how much of the second currency it takes to buy one unit of the first currency. If the price of the EUR/USD is 1.3635 it costs 1.3635 US dollars to buy one euro.
If you want to find out how many euros it costs to buy one U.S. dollar we need to flip the pair to USD/EUR. To find out this rate, divide 1 by 1.3635 (or whatever the current rate is). The result is 0.7334. It costs 0.7334 euros to buy one USD based on the current price. The price of the currency pair constantly fluctuates, as transactions occur around the globe, 24-hours a day during the week.
- Many currency pairs will move about 50 to 100 pips (sometimes more or less depending on overall market conditions) a day. A pip is the fourth decimal place in a currency pair, or the second decimal place when JPY is in the pair. When the price of the EURUSD moves from 1.3600 to 1.3650, that's a 50 pip move; if you bought the pair at 1.3600 and sold it at 1.3650 you'd make a 50 pip profit.
- The profit you made on the above theoretical trade depends on how much of the currency you purchased. If you bought 1000 units (called a micro lot) each pip is worth $0.1, so your profit equates to $5 for a 50 pip gain. If you bought a 10,000 unit (mini lot) each pip is worth $1, so your profit is $50. If you bought a 100,000 unit (standard lot) each pip is worth $10, so your profit is $500. This assumes you have a USD trading account.
- How much each pip is worth is called the "pip value." For any pair where the USD is listed second in the currency pair, the above mentioned pip values apply. If the USD is listed first, the pip value may be slightly different. To find the pip value of the USD/CHF for example, divide the normal pip value (mentioned above) by the current USD/CHF exchange rate. For example, a micro lot is worth $0.10/0.9435 = $0.1060, where 0.9435 is the current price of the pair, and subject to change. For JPY pairs (USD/JPY), go through this same process, but then multiple by 100. For a more detailed explanation, see Calculating Pip Value for Different Forex Pairs and Account Currencies.
- For trading purposes, the first currency listed in the pair is always the directional currency on a forex price chart. If you pull up a chart of the EUR/USD, and the price is moving higher, it means the EUR is moving higher relative to the USD. If the price on the chart is falling, then the EUR is declining in value relative to the USD. The attached chart shows this.
- One of the best ways to learn about forex is to see how prices move in real-time, and place some trades using fake money (so there is no actual financial risk to you). Check out Practice Day Trading with These Simulators for some options on where to hone your forex trading skills.
Forex Market - Final Word
Understanding the above concepts will help you grasp what's happening when you see a forex pair rising or falling on a chart. It will also help you see the profit potential available from such moves. For more on starting out in forex trading, see Minimum Capital Required to Start Day Trading Forex and How Much Money Can I Make Forex Day Trading? Both these articles provide more examples of how profit is realized in the forex market, as well as introduce new concepts, such as leverage.