Foreign exchange (forex) trading entails purchasing and selling of currencies in forex markets. The foreign exchange markets include cash markets (also known as spot markets) or derivatives markets where forwards, futures, options and currency swaps are traded.
Forex trading is done primarily to hedge against risks such as fluctuation in global currencies and changes in interest rates, and to protect against the geopolitical risks. It is imperative to understand that international currencies exchange hands to facilitate international trade and commerce.
To understand forex trading well, it is important to understand the following key terms:
Currency pair: The currency trading is done in pairs. This means one currency is bought in exchange for the other. The first currency in the pair is known as base currency while the second is called quote currency. In the forex market, a currency pair is bought and sold as one unit. On purchasing a currency pair, a trader receives the base currency and sells the quote currency. The common currency pairs include EUR/GBP, AUD/NZD and EUR/CHF.
Pip: A percentage in point (pip) refers to the change in exchange rate of a currency pair. All major currencies, in the forex market, are priced to four decimal places. A pip is the smallest unit which is equal to one unit of the fourth decimal place.
Forex spread: Difference between a broker’s buy rate and sell rate is known as spread. It is essentially the difference between the bid price and ask price.
Bid price: When a forex broker buys a base currency from a trader in exchange of quote currency, he pays the ‘bid’ price.
Ask price: When a broker sells the base currency in exchange for quote currency, the price at which the broker sells is known as ‘ask’ price.
Leverage: Leverage refers to the short-term loan from a broker to help you make large positions with relatively less money. So, leverage enables investors to hold big positions with something small.
Margin: A margin account in the context of forex trading entails borrowing funds from the broker to raise the size of position in the market. It essentially refers to trading with leverage that enables a trader to increase their risk and return.
Spot exchange rate: A spot exchange rate is the price decided between the two parties to exchange one currency for another. For spot currency transactions, settlement happens two days after the transaction takes place. It is also referred to as T+2 or settlement date.
Currency arbitrage: It is a forex trading strategy where traders buy and sell the same currency pair at different prices at the same time to be able to make money. The traders who carry out arbitrage are known as arbitrageurs.
Major currencies: The currencies that are traded against the US dollars are known as major currencies. These include USD/JPY (US dollar & Japanese Yen), USD/CHF (US dollar & Swiss Franc) and USD/CAD (US dollar & Canadian dollar).