Part Two: Essential Forex Trading Terms You Must Know

Part Two: Essential Forex Trading Terms You Must Know

Forex is brimming with notions and words that might put off some people who aim to invest in the world's largest financial market

Before you start trading, it may be wise to familiarize yourself with some basic FX terminology. Our guide here can help you lay a reliable foundation and a good start in your quest to become an accomplished trader.

  1. Starting Small, with a PIP.

The acronym PIP translates to Percentage in Point and defines the smallest movement reflected in a currency pair's exchange rate. Depending on the context, this usually is one basis point (0.0001) for pairs such as EUR/USD, GBP/USD, or USD/CHF, and .01 in the case of other pairs such as USD/JPY.

You should also know that the PIP is the 4th decimal on a price quote for a currency pair, and people use it to measure the pair’s value.

Let us look at an example: the EUR / USD pair. Its price quote currently sits at 1.2111. With 1 Euro you can buy 1.2111 US Dollars. If the PIP increases by 0.0001 to 1.2222, this means that you can get slightly more US Dollars for every Euro.

  1. BID/ASK Price, Spread, Dealing Desk, and No-Dealing Desk Brokers – how they make money.

If you check any FX broker, you can see they list two different prices for a currency pair: the bid price and the ask price.

The bid price is the price at which you can SELL the base currency, while the ask price shows the price at which you can BUY the base currency.

The difference between these two prices is the spread. There are two distinct types of spreads: fixed and variable (floating).

Types of FX Brokers – Dealing Desk and No Dealing Desk

Dealing Desk Brokers make money through fixed spreads and supply liquidity to clients without using external providers. They are also called market makers, as they create markets for investors, meaning they take the other side of a clients’ trade. In other words, they set bid and ask prices and wait for traders to open their positions to take advantage of the spreads between the two prices.

No Dealing Desk Brokers do not take the other side of their clients’ trade, as they work with external liquidity providers to give clients variable spreads. They grant unfiltered access to interbank market rates of exchange via ECN or STP networks.

An ECN (Electronic Communication Network) broker has its trading platform electronically connected to the network of international banks or liquidity providers, matching up buy and sell orders for financial products automatically. The ECN system links brokers, individual traders, and liquidity providers, allowing them to execute trades directly between themselves, without intermediaries.

A STP (Straight Through Processing) broker routes some their clients’ orders directly to the market, acting as middlemen. They typically send the orders directly to its liquidity providers for processing when the client trades, without human intervention.

  1. What is a lot in Forex?

A lot in Forex trading refers to the number of currency units you can open. 1 Standard Lot is worth 100,000 units of the base currency.

If we go back to the EUR / USD example, opening a position would translate to a trade size of $100,000, as the Euro is the base currency. One standard PIP values $10, so a 5 PIP incremental movement in a buy trade would stand for a $50 gain.

  1. Leverage in Forex– the double-edged sword.

Using leverage, a trader can access a more substantial sum of money with a smaller investment of his own and the rest borrowed from a broker.

Leverage volumes are expressed in ratios. For instance, to open a 5k position, you could use $500 of your own money, while the rest of $4,500 can come from your broker. In this case, your leverage will be 10:1.

Suppose you learn how to use leverage well. In that case, it can turn into a powerful trading weapon, as it has the potential of multiplying your earning on successful trades and diversify your portfolio by freeing up some of your funds. At the same time, lousy leverage choices can lead to unwanted repercussions.

  1. Balance, margin, and equity – understanding how your trading account works.

Balance, margin, and equity are all integral parts of your trading account terminology. As learning what each one of them means is critical, here is what you should know:

Balance

Balance refers to the amount of funds available in your trading account for withdrawal or use. Balance does not account for open positions, and its value only accounts for deposited money and the profits/losses from closed positions.

Margin

People often tend to confuse margin and leverage. The margin is a small part of your account equity set aside and used as a deposit to keep positions open. By contrast, leverage is a byproduct of margin and allows an individual to control larger trade sizes and potentially enlarge their returns.

Two more margin-related concepts:

Maintenance margin: the minimum account balance you need before the broker requires more funds to pay the loan.

Margin call: when your account is in danger due to low margin levels.

Equity

When it comes to trading, equity is an exact representation of your account's total value. In simpler words, equity includes balance, plus your profit/losses from open trades. However, when you have no open positions, the account's equity and balance coincide.

  1. What are bearish and bullish markets?

Falling prices and investor pessimism define bear markets while rising prices and positive market trends signal bull markets. During bearish times, stocks lose their value, economies slow down, and unemployment soars. On the other hand, bullish periods see stocks flourishing, economies skyrocketing, and unemployment figures going down.

Note that neither bullish nor bearish markets last forever because volatility keeps breaking their cycles. When prices fluctuate, and the markets swing from one direction to another, you have more trading options, but with increased risks due to growing market uncertainty.

Five key things to remember:

  • Understanding concepts such as PIP and Lot can help you figure out how much money it is safe to use for every position you open.
  • Treat leverage with the utmost care: it can always make or break your trading!
  • Balance, margin, and equity are all integral parts of your trading account terminology. Master them quickly, and you will manage your funds better!
  • Falling prices and investor pessimism define bear markets while rising prices and positive market trends signal bull markets.
  • The difference between BID/ASK price is called spread, through which Dealing Desk Brokers make money.

Sources: Investopedia.com, thebalance.com, babypips.com

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