Terms Of The Trade: 5 Terms To Learn Before You Start Forex Trading
Even if you’re relatively new to stock trading, you’ve likely heard people talk about forex trading. The term “forex” is an abbreviation for “foreign exchange,” and it refers to the practice of trading foreign currencies.
Forex traders attempt to take advantage of the fact that global currencies often fluctuate in relative value. For example, if a forex trader starts in U.S. dollars but believes that the dollar is expected to weaken relative to the euro, he or she will exchange dollar funds for euro funds. The hope is that those funds can be exchanged back for more dollars than the original amount at some point in the future.
5 Terms To Memorize
1. Exchange Rate
Forex traders often watch a set of numbers called “exchange rates.” An exchange rate is the rate at which one currency can be exchanged for another currency. A currency like the U.S. dollar has unique exchange rates with all other global currencies at any given time, and forex traders try to profit off of the daily fluctuations in these rates.
When it comes time to making a forex trade, pips and spreads come into play. A “pip” is the smallest forex value denomination and is equal to 0.0001.
Much like the spread stock traders are used to, a forex spread is the difference between the buy price and the sell price of a given currency pair.
For example, a typical forex quote for a U.S. dollar/euro trade will look something like this:
- USD/EUR 1.2530/1.2535
In that example, there is a 5-pip spread between the buy price (also called the bid) and the sell price (also called the ask).
Currencies are typically traded in “lots.” One lot is equal to 100,000 units of the base currency. Another way of thinking about lot size is that a 1-pip movement for a standard lot is equal to a 10-unit overall change.
Forex markets are typically much less volatile than equity markets, which means that large position sizes are needed to make sizable returns on trades. Many forex traders solve this problem by relying on margin, or money borrowed from a broker. Of course, this money comes at a price, and forex traders who rely on margin must pay interest on this borrowed money over time.
Forex trading can be a very profitable endeavor, but it can also prove very costly if traders don’t fully understand what they are getting into. Knowing the basics of forex trading outlined above is a good first step in the right direction.
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