Ever read an article about Forex trading that made your head spin?
If you had, then you probably wanted to ask the writer if there's an English version of that article because some of the terminologies he or she used are foreign to you.
Well, fortunately, you're in the right place because this article defines all the basic Forex trading terminology that you should be familiar with so that you can move on to advanced Forex topics.
The terms discussed here: pips, leverage, lot sizes, spread, and brokers.
Pip is probably the most common word you'll hear or read about in the world of Forex trading, and you may have seen "pip" pop out (that sounds funny) a few times in some of the articles in Intellinvestors.
But, if the next step you take is to grab a dictionary, prepare to be disappointed because its definition there is different.
It's common for people in finance to shortcut everything, including words and phrases — FIFO (first in, first out), LIFO (last in, first out), and the most obvious one, in this case, foreign exchange, aka Forex.
Pip isn't excluded.
It's just the shortened form of percentage in point.
It starts at the fourth decimal place of a currency pair's quotation.
For example, the EUR/USD is quoted at 1.1901. If the quote moves up to 1.1909, then that's an 8-pip jump (1.1909 – 1.1901 = 0.0008 or 8 pips).
2. Lot sizes
Now, it wouldn't make sense to start counting pips at this point if you have no clue about how it affects trades.
Here's an elucidation: the direction of the pips determines your profit or loss from a trade, and that direction is either an increase or decrease in value.
You already know that to make a profit, you need to sell something at a price that far exceeds the cost.
So, if you had bought the EUR/USD at the exchange rate of 1.1901 and sold it for 1.1909, then you profited with $0.0008 or eight pips — not much, right?
But that's when lot sizes make it interesting.
Obviously, you wouldn't waste time haggling over trifles, so trading in more substantial quantities makes it worth your while.
Traders don't usually trade a single currency for another — the airport might be a better place to do that.
In actuality, retail traders trade units of currencies in hundreds of thousands — sometimes even millions!
Therefore, the mere $0.0008 gain would be amplified (by trading 100,000 units of Euros) to an $80 profit.
The lot sizes in Forex:
Micro Lot = 1,000 units
Mini Lot = 10,000 units
Standard Lot = 100,000 units
The next logical question you may have is this: Does that mean I have to have $119,010 (€100,000) in my trading account to gain that $80 in the sample transaction?
The answer is yes, and no.
Yes, because if you have that amount of risk capital, there's no reason for you not to do it.
And, no, because most brokers can provide you leverage.
Leverage allows you to take on a trade with a volume larger than the size of your trading account.
When you start trading currencies, you have the option to use the leverage provided by your broker.
Think of it as borrowed money.
Here's how it works: Going back to the EUR/USD example, you know that to get the $80 profit, you must have at least $119,010, but using leverage would permit you to put down only $1,000 to collect that gain.
It's kind of like down payment, but there are no monthly installments for you to concern yourself about.
Everything takes place in your trading account.
Here's the effect: The $1,000 taking on a €100,000 position will have a higher pip value that can go in two directions. At $10 per pip, you either end up with an $80 profit or an $80 loss to your account.
That’s why you’ll hear most people in the Forex industry say that leverage is a double-edged sword because you either finish the day + 8% or – 8% (from a $1000 account) with that particular transaction.
And, mind you, an 8% move in one day in other investments is high.
Do you know how your broker earns its revenue?
The answer is through the spread.
The spread is the difference between the quoted buy and sell prices for a currency pair.
In your trading platform, you'll see that the price to buy a currency pair is much higher than the cost to sell it, and that's the revenue of your broker.
Brokers may quote the currency pairs they offer distinctively from other brokers, and often it's one of their value propositions to acquire clients.
It's especially helpful for you to know what your broker's spreads are because it can affect the way you trade.
A higher spread would obviously mean that it takes a bit more time for you to see profits as opposed to having narrower ones.
Lastly, leverage plays a role in spreads.
When you employ sizable leverage, your broker jumps for joy because it's not just you who can magnify earnings but your broker as well.
The only difference is that your broker is guaranteed with income while you, on the other hand, are not.
The sample quote from the above image for the EUR/USD is 1.1901, which is the BUY price.
If you want to sell it, the quote will be lower, say, 1.1899, denoting a 2-pip spread.
Factoring in the 100x leverage, you have the potential to earn or lose $80 from the sample transaction.
But, your broker stands to gain a guaranteed $20 from the spread regardless if you win the trade or not.
This last term is here just in case you still don't know what it means.
A broker is your link to the market and is often represented by a company, not necessarily a sole individual anymore.
A good broker provides you with the necessary tools, flawless trade execution, and full-on guidance to help you in trading.
Be sure to trade with a reputable company because your broker will determine a large portion of your success.
Learn how to select the best Forex broker for you by reading our guide.
By remembering the basic terms discussed here, you can brace yourself for more reading materials that contain Forex jargon.
You can also appreciate now how it all ties in from the definition of a pip to the main moneymaker of your broker as all these terms are very closely related.
Try to impress your friends by showing off some of the things you learned here. *Wink*