Understanding Currency Quotes

In the forex market, all price quotes are represented by two prices, known as the bid price and the ask price. Both the bid price and ask price represent the exchange rate of the base currency pair against the quoted pair, except they serve two different functions. The bid price indicates the price at which your currency dealer is willing to buy the base currency from you in exchange for the quoted currency. The ask price indicates the price at which your currency dealer is willing to sell you the base pair in exchange for the quoted currency. There is always a difference between the bid price and the ask price; this difference is known as the spread. The spread is usually less than five pips on major currency pairs. Cross-currency pairs such as GBP/JPY may have much higher spreads. The spread is the way a currency dealer earns money for executing a trade.

Figure 1.2 shows the difference between the bid and ask prices offered in the forex market. The difference between the two prices is known as the spread.

Using the prices quoted in Figure 1.2, if a trader wanted to buy EUR/USD, his currency dealer would sell it to him using the ask price of $1.4002. To sell the position at least at breakeven, the trader needs the bid price to move up two pips, to $1.4002. Alternatively, if a trader wanted to sell the EUR/USD, the currency dealer would sell it to him at the bid price of $1.4000 and the trader would need the market to fall by two pips before he could sell it at the ask price for a breakeven trade. The two-pip spread in this EUR/USD example is the cost of doing business with this currency dealer.
















FIGURE 1.2 Understanding Price Spreads MetaTrader, © 2001–2008 MetaQuotes Software Corp.

Long versus Short

The terms long and short simply refer to the position a trader has taken with a trade; the trader has either bought or sold it. The term long simply means that you have bought the currency; the term short means you have sold it. For example, if a trader decides to buy GBP/USD, it means she has gone long British pounds and short U.S. dollars because she has bought the GBP and sold the USD.

TABLE 1.5 Mechanics of a GBP/USD Currency Trade

What Is a Pip?

The term pip is an acronym for percentage in points and is used to measure the change in exchange rates on the forex market. A single pip represents the smallest possible decimal change a currency quote may move, and it is the standard on which profit and loss are calculated. Currencies are quoted in decimal format to 1/1,000th of a percent unless the currency pair contains the Japanese yen. Currencies quoted against the Japanese yen are in decimal format to 1/100th of a percent. Using a quote for GBP/USD as an example, a change in price from $1.5600 to $1.5650 represents a change of 50 pips.

What Is a Pip?

The term pip is an acronym for percentage in points and is used to measure the change in exchange rates on the forex market. A single pip represents the smallest possible decimal change a currency quote may move, and it is the standard on which profit and loss are calculated. Currencies are quoted in decimal format to 1/1,000th of a percent unless the currency pair contains the Japanese yen. Currencies quoted against the Japanese yen are in decimal format to 1/100th of a percent. Using a quote for GBP/USD as an example, a change in price from $1.5600 to $1.5650 represents a change of 50 pips.

How a Currency Trade Works

The way a currency is simultaneously bought and sold during a trade is confusing for many new traders, so an example will help clarify what happens under the hood of a currency trade. Assume for a minute that you are interested in buying the British pound against the U.S. dollar, which is listed as GBP/USD in your trading software. The base pair is the British pound; the quoted pair is the U.S. dollar. If the quoted exchange rate is $1.59 and you are trading one standard lot of currency, it will require 159,000 dollars to buy one British pound, or it will require selling 100,000 pounds to buy 159,000 dollars. Since we are interested in buying the pound, we want the exchange rate to increase, allowing us to sell our pounds at a higher rate for more dollars than we sold to buy the original 100,000 pounds. As an example, Table 1.5 illustrates how a currency trader realizes a profit or a loss using a single standard lot GBP/USD currency trade.

How a Currency Trade Works

The way a currency is simultaneously bought and sold during a trade is confusing for many new traders, so an example will help clarify what happens under the hood of a currency trade. Assume for a minute that you are interested in buying the British pound against the U.S. dollar, which is listed as GBP/USD in your trading software. The base pair is the British pound; the quoted pair is the U.S. dollar. If the quoted exchange rate is $1.59 and you are trading one standard lot of currency, it will require 159,000 dollars to buy one British pound, or it will require selling 100,000 pounds to buy 159,000 dollars. Since we are interested in buying the pound, we want the exchange rate to increase, allowing us to sell our pounds at a higher rate for more dollars than we sold to buy the original 100,000 pounds. As an example, Table 1.5 illustrates how a currency trader realizes a profit or a loss using a single standard lot GBP/USD currency trade.

Currency Lots

Currencies are traded in standard lot sizes to facilitate efficient trading on the forex market. The standard retail lot is 100,000 units of the base currency. Most currency dealers offer 10,000-unit mini lots and 1,000-unit micro lots. Some currency dealers offer a 100-unit nano lot. Positions can be sized larger by purchasing multiple lots. Fortunately, you don’t actually need $100,000 in your trading account to buy a single standard currency lot. Currency dealers offer various levels of leverage, allowing you to control full-sized lots with significantly less capital in your account. We discuss margin and leverage later in this chapter.