What is Forex?
Forex is a type of CFD. Forex – or FX - is an abbreviation for ‘foreign exchange’ and is used to describe trading in the foreign exchange market by investors and speculators. The Forex market is the largest and most liquid market in the world with daily turnover of around $5 trillion. The power and size of this market is phenomenal and it dwarfs all of the major stock exchanges around the world. (See Chart 1)
In a Forex trade, you are simultaneously buying one currency and selling another. The buy/sell decision in forex is the same as the basic principle underpinning the share market. If a trader believes that a company’s share price will rise (or the currency will strengthen), then he or she would buy. If a trader believes that the share price will fall (or the currency will weaken), then he or she would sell.
Let’s take the Australian dollar and US dollar pair (AUD/USD) as an example. Imagine a situation where the AUD is expected to strengthen in value relative to the USD. In this case, a trader would buy AUD and sell USD. If the AUD actually does strengthen in value, the purchasing power to buy US dollars has increased. Therefore, the trader is now able to buy back more USD than they had to begin with, resulting in a profit.
What is an exchange rate?
The Forex market is quoted as one currency in relation to another. The first currency listed is the base currency. The second currency listed is the quote currency. For example, in the EUR/USD currency pair, the Euro is the base currency and the US dollar is the quote currency.
The price represents how much of the quote currency is needed for you to get one unit of the base currency. Let’s assume the EUR/USD is trading at 1.3050. This means that for every 1 euro of the base currency (EUR), you would get $1.3050 of the quote currency (USD).
How do I read an exchange rate?
There are two types of quotes:
Direct quote: The price of the base currency in terms of the quote currency (e.g. in Japan, a direct quote for the USD would be 100.28 JPY = USD 1)
Indirect quote: The price of the quote currency in terms of the base currency (e.g. in the EU, an indirect quote for the USD would be USD 1.33 = 1 EU)
Regardless of whether the pair is a direct quote or indirect quote, the currency pair always has a bid price and ask price. The bid price is price at which the trader sells the currency and either initiates a short (sell) trade or closes a long (buy) trade. The ask price is price at which the trader buys the currency and either initiates a long (buy) trade or closes a short (sell) trade.
What is a PIP?
Pip is an acronym for ‘percentage in point’ and is the smallest price increment in Forex trading. Most currency pairs are quoted to four decimal places, except the Japanese Yen pairs. The fourth spot after the decimal place (100th of a cent) is generally what traders look at in order to count pips. One point movement in that fourth decimal place equals one pip. For example, if the AUD/USD was trading at 1.0500 and the price moved to 1.0501, then this represents a one pip movement.