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What is a Pip?
Currencies trade in “fractions” of a cent: these are the smallest movement in price an exchange rate can make during forex trading. This fraction is called a "pip" or Price Interest Point. Currencies trade in pips because exchanges of currencies for speculative and other reasons are generally for large amounts and this makes representation in one currency more accurate in another. A pip represents 1/100 of 1 cent.
Therefore the following currency pairs correspond to 1 pip or the smallest price increment that the rate can make.
EUR/USD = 0.0001 or a move from 1.2104 to 1.2105 or to 1.2103
GBP/USD = 0.0001 or a move from 1.8210 to 1.8211 or to 1.8209
USD/CHF= 0.0001 or a move from 1.2546 to 1.2547 or to 1.2545
USD/JPY = 0.01 or a move from 110.38 to 110.39 or to 110.37
What is the Bid/Ask Prize?
Like equities, foreign exchange has a bid price and an ask price. The bid price is where the market maker is willing to buy. The ask price, is where the market maker is willing to sell. For traders, the reverse is true. The bid price is where a trader can sell, while the ask price is where a trader can buy.
The bid price is always less than the ask price. This makes logical sense, as a market maker, like any investor, wants to buy low and sell high.
The spread between the bid and the ask price is called the bid/ask spread or dealing spread. The bid/ask spread is the premium that market makers charge to provide constant liquidity to a client base.
How do I know which currency I am buying and which I am selling?
In the FX market currencies are always priced in pairs; therefore all trades result in the simultaneous buying of one currency and the selling of another.
The objective of currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold.
Consider the following example:
The current bid/ask price for USD/JPY is 110.02/110.07, meaning you can SELL $1 US for 110.02 Yen or BUY$1 US for 110.07 yen.
Suppose you decide that the US Dollar (USD) is undervalued against the Japanese Yen (JPY).
Since the US dollar is the base currency, to execute this strategy you would BUY the pair i.e. buy dollars (simultaneously selling yen), and then wait for the exchange rate to rise.
How can I enter a short (sell) order to sell a currency pair that I don’t own?
In every currency trade, you are borrowing one currency to buy another. For example, if you buy the USD/JPY, you are simply borrowing yen to buy US dollars; if the US dollar rises in value, you will be able to sell them for more yen than you borrowed, and thus profit accordingly.
If on the other hand you enter a short, or sell, order on the USD/JPY, you are simply borrowing US dollars to buy Japanese yen. If the yen rises in value, then you will be able to sell them back for more dollars than you initially borrowed – and will reap a profit in doing so.
In every trade, regardless of whether you are buying or selling the currency pair, you are buying and borrowing a currency.
What is the difference between a market maker and a broker?
In the equities, futures, and currency markets, the vast majority of orders are executed by what is known as a market maker – a central party whose primary role is to buy from sellers and sell to buyers, thus ensuring that the market can operate smoothly.
Market makers operate by charging a spread – a small difference between the price they buy at and sell at. For example, the market maker will buy from a seller at a price of 45, and sell to a buyer at a price of 50 – thus reaping a profit of 5. All market makers charge a spread, as it is their primary source of compensation for the service they provide.
Brokers, on the other hand, charge a commission – a per trade transaction cost they apply for their services. Trading directly with a market maker – and thus bypassing the commission costs imposed by brokers – is fairly difficult in the equities and futures market, and is generally associated with expensive software fees or clearing fees.
In the currency market, though, no such hindrances exist: clients can bypass brokers all together, and can trade directly with the market maker while incurring the spread as their only transaction cost.
What is leverage?
Leverage is a means of enhancing returns or value without increasing the investment size. Leverage allows you to magnify your potential returns by trading more than you actually deposit.
This means with a $100 margin deposit you can place a 10,000 base currency position in the market. In the event the total value of the account falls below margin requirements, the system automatically closes all open positions.
This prevents clients' accounts from falling below the actual available equity particularly in a highly volatile, fast moving market.
Bear in mind, though, that leverage is a double-edged sword. Without proper risk management, this high degree of leverage can lead to large losses as well as gains.
What is margin?
Margin is the aggregate amount of customer cash pledged against the aggregate open position or positions. The margin pledged is a function of Maximum Trading Leverage Ratio. The higher the leverage the lower the pledged margin needed to carry the position. The lower the leverage, the higher the margin needed to carry the position.
By trading on margin traders have the ability to control trading positions much larger than the amount of cash pledged. Leverage is a very nice tool to enhance the performance of a trading account but without the correct controls in place can very easily be used incorrectly and the trader can run the risk of ruin.
The amount of leverage or gearing used during trading is a mater of risk management and needs to be addressed accurately by each trader to have optimal market exposure. The margin pledged for leverage is not a down payment on a purchase of equity as in the stock market but rather a performance bond to insure against trading losses.
Most market makers provide a Minimum Trading Leverage Ratio of 50:1, which can also be represented by 2%. At that ratio, a 100,000 EUR position would require $2,419 of Margin at an exchange rate of 1.2097. This is calculated by taking the US$ equivalent of 100,000 EUR or US$120,970 and dividing by the 50:1 leverage ratio or calculating 2% of the value.
Margin required = $120,970 / 50 = $2,419 or
Margin required = $120,970 x 2% = $2,419
What is a margin call?
Accounts are set-up on a default margin on 1% (approximately 100:1 leverage). Meaning, clients must maintain in excess of $1000 in the account for every lot (100,000 position) that is open on the trading account. ($1000 is 1% of 100,000).
The following is an example of a margin call situation:
Assuming account balance is $8000:
If the trader buys 6 lots of EUR/USD ($600,000) at a rate of .8960, which uses up $6000 ($1000 x 6) of the account’s usable margin, leaving an available margin of $2000.
If the position were to go against the client by 34 pips to .8926, the floating trading loss would be $2040 and open positions will be closed on a margin call. from the computer without constantly monitoring the market.
What is a interest rollover?
When a trading position is still open at 5 pm EST, a currency trader need to pay a daily rollover interest on that OPEN position. If you don't want to pay the interest rollover, be sure the position is closed before 5pm EST. On Wednesdays, the amount added or subtracted to an account as a result of rolling over a position tends to be around three times the usual amount. This "3-Day" rollover accounts for settlement of trades through the weekend period.
When your account is set on 2% margin or 50:1, you can earn interest on daily rollover.
Where is the Central Location of the FX Market?
Currency trading is not centralized or an exchange, as with the stock and futures markets. The FX market is considered an Over the Counter (OTC) or ' Interbank ' market, due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. |
