Forex 101 Series: Defining Terminologies

You can find the first part of this article here. I'm going to be talking about some terminologies that will aid understanding.

Explaining Some Terms

Leverage And Spread

Forex is commonly traded in specific amounts called lots, or basically the number of currency units you will buy or sell. A “lot” is a unit measuring a transaction amount. When you place orders on your trading platform, orders are placed in sizes quoted in lots. It’s like an egg carton (or egg box in British English). When you buy eggs, you usually buy a carton (or box). One carton includes 12 eggs.

The standard size for a lot is 100,000 units of currency, and now, there are also mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units.

Trading forex profitably before the advent of retail trading required huge capital, but through the use of leverage, retail trading became possible and profitable. If the exchange rate of the EUR to the USD is 1.3256 and you purchase 2 EUR, that will be equal to 2×1.3256=2.6512USD. If after two days, the exchange rate is now 1.3860, then in dollar, that will be 2×13860=2.7720. Net profit = 2.7720 - 2.6512= 0.1208USD... Ouch!! Not so profitable, eh??

Now imagine you could buy 200,000EUR (2 lots), your profit will become 0.1208 × 100,000= 12800 USD, profitable yes? Hell yes!...

You are probably wondering how a small investor like yourself can trade such large amounts of money. Think of your broker as a bank who basically fronts you $100,000 to buy currencies. All the bank asks from you is that you give it $1,000 as a good faith deposit, which it will hold for you but not necessarily keep.

Sounds too good to be true? This is how forex trading using leverage works.

The amount of leverage you use will depend on your broker and what you feel comfortable with. Typically the broker will require a deposit, also known as “margin“. Once you have deposited your money, you will then be able to trade. The broker will also specify how much margin is required per position (lot) traded.

For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account. No problem as your broker would set aside $1,000 as a deposit and let you “borrow” the rest.

Of course, any losses or gains will be deducted or added to the remaining cash balance in your account. The minimum security (margin) for each lot will vary from broker to broker. In the example above, the broker required a 1% margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position.

Let’s say you want to buy 1 standard lot (100,000) of USD/JPY. If your account is allowed 100:1 leverage, you will have to put up $1,000 as margin. The $1,000 is NOT a fee, it’s a deposit. You get it back when you close. The reason the broker requires the deposit is that while the trade is open, there’s the risk that you could lose money on the position! Assuming that this USD/JPY trade is the only position you have open in your account, you would have to maintain your account’s equity (absolute value of your trading account) of at least $1,000 at all times in order to be allowed to keep the trade open. If USD/JPY plummets and your trading losses cause your account equity to fall below $1,000, the broker’s system would automatically close out your trade to prevent further losses. This is a safety mechanism to prevent your account balance from going negative.

Bid And Ask Price

Forex brokers will quote you two different prices for a currency pair: the bid and ask price. The “bid” is the price at which you can SELL the base currency. The “ask” is the price at which you can BUY the base currency. The difference between these two prices is known as the spread.

The spread is how “no commission” brokers make their money. Instead of charging a separate fee for making a trade, the cost is built into the buy and sell price of the currency pair you want to trade. From a business standpoint, this makes sense. The broker provides a service and has to make money somehow.

They make money by selling the currency to you for more than they paid to buy it, and they also make money by buying the currency from you for less than they will receive when they sell it. This difference is called the spread.

It’s just like if you were trying to sell your old iPhone to a store that buys used iPhones. In order to make a profit, it will need to buy your iPhone at a price lower than the price it’ll sell it for. If it can sell the iPhone for $500, then if it wants to make any money, the most it can buy from you is $499. That difference of $1 is the spread.

Note: This article contains a lot of excerpts from babypips.com and as a matter of facts is inspired by the knowledge and ease of learning their material affords

Thanks for reading...