Each day, more and more traders find the ever expanding Forex market; making the shift from other asset classes for a variety of reasons.
Around-the-clock trading availability, wide geographical dispersion, and pure unbridled opportunity have contributed to the growth in this market, as average daily volume in the FX Market nears $4 trillion dollars ($3.98 Trillion per the Bank of International Settlements).
That’s nearly $4 Trillion, in one day.
The goal of this article is to explain the nuances of the Forex market, highlighting key similarities and differences from other popular trading vehicles.
The FX Quote
The first thing that most new traders will notice is the FX quote. When trading stocks or futures, quotes can generally be read easily, as they are one-sided; meaning when you read a quote on Google, you are looking at the price at which traders can buy or sell Google. However when you want to trade a currency, such as the Euro, you have quite a few options. If you want to trade the Euro, you can pick a variety of different ways of doing so.
You can choose to pair the Euro with the US Dollar. This would be the EUR/USD currency pair, which is the most common, liquid currency pair in the world.
Or perhaps you wanted to make a different type of play and choose to marry the Euro with another currency, such as the Australian Dollar (abbreviated AUD), or the Japanese Yen (abbreviated JPY).
Traders can choose to trade the Euro in a wide variety of ways, based on their goals and prevailing opportunities in the market.
This really isn’t all that different than stocks.
Let’s go back to our quote on Google. If GOOG is trading at $650.00, we can think of this in currency terms as GOOG/USD at $650 (Google quoted in terms of US Dollars is trading at $650).
We can also quote Google in terms of Euros.
Let’s say that the spot quote on EUR/USD was $1.50, meaning that each Euro was worth One Dollar and Fifty Cents. We can then divide our $650.00 price on Google with the exchange rate of 1.5 Dollars for every Euro (remember 1.50 is euro’s quoted in terms of dollars) to get the equation ($650/1.5 = $433.33). So Google, quoted in terms of Euros with the above information would look like:
GOOG/EUR = $433.33
Just like any other asset class, as the trader I want to look to buy low and sell high. Or sell high, and buy back to cover at a lower price for short positions.
When we sell a currency pair, we are selling it relative to another currency. Let’s take our EUR/USD example from above. If I were to sell the EUR/USD currency pair, I would be selling Euro’s. I would also be buying dollars. My goal in this trade would be for Euros to weaken, the Dollar to strengthen, and price to go lower so that I could cover my short position at a lower price.
Five Digit Pricing
Another key difference in the quote of an FX pair is the fact that prices are offered, in many cases, to five digits. Most markets are denominated in a much more common sense manner, using prices that resemble those which we see in our everyday lives, quoted to 2 decimal places. When I want to buy some flour at the store, the price will be quoted 2 digits beyond the decimal place; like $4.56. If I want to buy a car, once again, prices are quoted 2 places past the decimal with a price such as $54,367.31.
But in the FX Market, more precision is needed, and prices are quoted up to 5 digits beyond the decimal. Let’s look at a quote on EUR/USD for further examination.
Let’s assume that the bid on EUR/USD is 1.27218.
The first three digits of this number are just like any other price that we will see. In this case the Euro is worth One dollar, and 27 cents. The digits after help further define this quote.
The next 2 digits in this quote are called ‘pips,’ which is short for ‘percentage in point.’ In this quote, the Euro is trading at 1 dollar, 27 cents, and 21 pips, or 21/100ths of a cent. Another way of saying this same quote would be One dollar, 27 cents, and 21 pips.
The fifth digit of this quote is called a ‘fractional pip,’ and some forex brokers do not offer this fifth digit. The fifth digit further helps define price, and represents ‘tenths of a pip.’ In the case of the above quote, it can be read One dollar, 27 cents, 21 pips, and 8/10th of a pip.
Below is an example of another quote, with full annotation.
Many traders first entering FX wonder why such precision is needed with prices. That leads us into the next unique aspect of the FX Market.
The current average daily range (over the past 14 days) of the EUR/USD currency pair is approximately 115 pips. Using the EUR/USD current market price of (1.2726 as of this writing), the average range is approximately .9%, or less than 1%.
This is much less volatility than many traders, including myself, are looking for.
In the FX market, leverage is available so that I can make these smaller moves work in the way that I want. For most traders in the United States, up to 50X leverage is available. Meaning, I could lever up a .9% daily move 50 times on my portfolio, theoretically allowing me to turn a .9% gain into a 45% gain at 50:1 leverage.
The thing that traders entering the FX Market have to keep in mind is that these excessive levels of leverage can be counter-productive.
Most professional traders keep their leverage inside of 10:1. Meaning, if they have $10,000 on deposit with their broker, they will keep their position sizes under $100,000. Or if they have $2,000 on deposit, they will keep their positions under $20,000.
To find leverage, we can simply multiply the account deposit times the leverage factor (such as 10X or 5X) to find the desired position size to stay inside of their desired leverage level.
Let’s walk through a full example together.
Let’s assume that our trader has $10,000 on deposit, and wanted to use a 2x leverage factor. This would allow them to open a trade of up to $20,000.
Let’s assume they wanted to speculate on the EUR/USD currency pair.
They could purchase (or sell) 2 standard lots (each standard lot is $10,000 of the base currency, or the second currency in the quote), to arrive at a position size of $20K.
Trader’s deposit: $10,000
Leverage Factor: 2X
Position Size: $20,000 (or 2 standard lots, as each standard lot is $10,000 USD)
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--- Written by James B. Stanley
You can follow James on Twitter @JStanleyFX.