Currency Trading for Dummies

Unless you have previous experience with the exact currency markets, do not expect to be an instant expert in how the markets move, nor the lingo of the market. We’ll run through four very basic concepts of the currency markets that we’ll call the currency trading for dummies list.

Pips
In the stock market, the smallest unit is the penny, thus second number following the decimal point is a penny. In the foreign exchange market, the smallest unit is a pip. In every currency pair, the fifth unit listed is the pip unit. So, if one were to trade the EURUSD, the pip would be the fourth number following the “1” in the quote. A move in the price of the EURUSD from 1.2000 to 1.2100 would be 100 pips, as 100 of the smallest unit were added in the rise in the currency pair.

Leverage
Leverage is a very important component of currency trading because it is what makes currency trading so profitable. Forex brokers allow investors to trade with leverage ranging from 20 to 50:1 in the United States, with maximum leverage amounts significantly higher around the world.

Leverage means that an investor does not have to put up a lot of their own money in order to make a lot of money. See, if you were to buy 1 Euro with US Dollars, the pair would have to change in price by 100 pips before you would have even a penny in profit. However, if you purchased the Euros using leverage, $1.2 dollars would allow you to purchase 50 Euros. Thus, for each 100 pip change in the price of the Euro, you would earn $.50 on a $1.20 investment. Extrapolating that out as a percentage, each .8% change in the price of the Euro means for you roughly 40% change in currency value, profits, or losses.

Pair Comparisons
Few markets operate like the forex market. Because currencies are traded against one another in relative value, the value of each currency is stated against another currency. Besides purchasing currency pairs where one currency is always bull/bear against every other global currency, there is no way to be bullish on any one currency.

That is to say, if the value of the EURUSD pair goes up, did the Euro go up in value or did the dollar go down? Or did they both go down, but the Euro went down less? Or maybe both gained value, but the Euro gained more value than did the dollar?

This kind of market makes it hard to pick which currency is “doing better” or “doing worse” based solely on how currency pairs rise and fall in value.

Bid/Ask, and Spreads
There are often two prices in a forex quote: the bid price, and the ask price.

The bid price is the price at which a forex broker is willing to buy the pair. The ask price is the price at which the broker is willing to sell the pair. The difference between the bid price and the ask price is the spread, the amount of money the broker makes for selling you currency.

You’ll notice that often the bid and ask prices are one to as many as seven pips different, depending on the pair. EURUSD, a highly active and high-volume pair is often sold with spreads of less than two pips. GBPJPY, however, is usually sold with spreads as high as five to seven pips. Keep in mind the relative value between a lot of GBPJPY and one pip. Since one pip is a smaller portion of the total GBPJPY quote as it is a portion of a EURUSD quote, the total proportional spread on GBPJPY may be much smaller as a percentage as a smaller pip spread on the EURUSD.

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