You know about exchange rates – in foreign currency trading, these are expressed using a currency pair and a value.

EUR/USD = 1.3206

1 euro will buy you 1.3206 US dollars.
So when this value goes up, the euro is stronger than dollar.
And when it goes down, the dollar is stronger than the euro.

The base currency is the first one written, so here EUR is the base currency – while the quote currency is the second, here USD.

Pips

Most currency pairs consist of five significant digits and most of them have the decimal point immediately after the first digit, EUR/USD = 1.3206

Here, one pip = the 4th decimal place, 0.0001 or 0.01%.
If the price moves up from 1.3403 to 1.3406, it’s gone up 3 pips

There’s one major exception – the Japanese yen, (which hasn’t been significantly revalued since the 1940’s) where it’s about 100 yen to the dollar at the moment
so here, if the USD/JPY pair = 102.46 then 1 pip = 0.01 – the fifth significant digit, but the second decimal place.

Pips are a quick and convenient way of keeping track of things – you can say the dollar dropped 30 pips this morning and people will know what you mean. You’ll also read, no doubt, of traders showing off by saying ‘I’m up 600 pips on the month so far’ – and because pips are relative and actual money is absolute, it’s an accurate comparison of their trading skills. Of course they might only have been trading with $250, and weirdly, you never see much of ‘I lost 600 pips this month…’

Buy/Sell & Long/Short

If you buy a currency pair – because you’re predicting that the base currency will rise in value relative to the quote currency – think of it as buying the base currency and selling the quote currency. This is known as a ‘long position’, or ‘going long’.
Similarly, if you sell a currency pair, you take a short position – equivalent to selling the base currency and buying the quote currency.

Bid/Ask Spread

No brokers’ fees, clearing fees, no government taxes…. But you will be paying something – because forex dealers, curiously enough, don’t do it just for the fun of it – what you’ll be paying is the bid/ask spread.

All forex quotes consist of two prices, the bid and the ask.

Bid = the price the dealer is willing to buy the base currency in exchange for the quote currency – so the bid is your selling price.

Ask = the price at which the dealer will sell the base currency in exchange for the quote currency – so the ask is your buying price.

The bid is the lower of the two – if it wasn’t, your broker would have a problem. The difference between bid and ask prices is the spread. (If you know anything of spread betting, you’ll understand what’s going on here – it’s actually where spread betting came from).

All this buying one currency, while selling another, makes it seem more complicated than it actually is in practice. Here’s an example:-

The currency pair is EUR/USD
The bid = 1.3501
The ask = 1.3504

The spread is 3 pips. So whether you buy or sell EUR/USD, ie. go long or short, the price is going to have to make up 3 pips for you before you start hitting profit. If you buy and the market price goes up 20 pips before you sell, you’ve made yourself 17 pips clear profit.

Rollover charges

This is a more minor detail, and not vital to your understanding of forex at present, but best to get it out of the way now
Quite simply, if you hold a currency, you receive interest on your holding. If you borrow a currency, you have to pay interest on your borrowing.

So, because every forex trade involves borrowing one currency to buy another, interest rates are part of deal. Interest is paid on the borrowed currency, while you earn interest on the bought currency.

At the end of the day – and your broker’s cut-off time will vary – the daily rollover charges are calculated on your currency position at that moment. You’ll either pay or earn an amount from the difference in interest rates. (This additional profit/loss is the basis of the so-called carry trade – which is for a later lesson).

Forex brokers calculate rollover charges using different recipes – you do have to check the small print here. Of course, if you close all positions before the end of the day’s trading – no rollover charges.

Next, is an important concept in retail forex 3. Leverage & Margin →