Introduction to financial markets
When you trade forex, you’re buying or selling a currency pair – such as EUR/USD, GBP/USD or USD/JPY. Let’s take a closer look at the anatomy of forex pairs.
The first currency in a pair is known as the base currency. The second is known as the quote currency (or sometimes as the counter currency). The price of a pair tells you how much of the quote you’ll need to buy a single unit of the base.
Say, for example, that EUR/USD is trading at 1.3010. The euro is the base, and the US dollar is the quote – meaning it costs 1.3010 dollars to buy a single euro. Forex traders look to profit from fluctuations in the exchange rates of currency pairs. So, if you think that the US dollar is going to strengthen against the Japanese yen, you might buy EUR/USD to capitalise on the move.
- EUR/USD is trading at 1.3010
- You buy €10,000 for $13,010
- EUR/USD moves up to 1.3110
- You can now sell your €10,000 for $13,110, earning you a $100 profit
However, if EUR/USD had dropped down to 1.2910, your position would have a $100 loss
But you don’t only have to buy currency pairs. If you think that the base currency is going to fall against the quote currency, you can sell the pair instead.
When you sell forex, you’re buying the quote currency by selling the base currency.
This gives you a position that earns a profit when your chosen pair falls in value, also known as a short position. It’s one reason why trading forex is so popular – there are no restrictions or extra charges associated with going short.
GBP/USD short example
- GBP/USD is trading at 1.3010
- You buy 13,010 USD (the quote) by selling 10,000 GBP (the base)
- GBP/USD falls to 1.2902
- You sell your $12,902 to get your original £10,000 back
- You keep the $108 as profit
However, if GBP/USD had risen instead, you would make a loss
What is a pip?
A pip is a single point of movement in a forex pair. In most FX pairs, a pip is equivalent to a single-digit move in the fourth decimal point of a currency pair’s price. If EUR/USD moves from 1.0717 to 1.0718, it has moved up one pip.
One important exception to this rule is currency pairs where the Japanese yen (JPY) is the quote currency. Here, a pip is equivalent to a single-digit move in the second decimal point. If USD/JPY moves from 110.08 to 110.03, it has moved down five pips.
This is because the yen is worth comparatively little to other major currencies.
You’ll often see an extra fifth digit after the pip on a forex quote. These are referred to as fractional pips (or pipettes). Sometimes, they’ll be written in superscript (smaller font size) to differentiate them from pips.
Calculating the value of a pip
A pip is worth 0.0001 (or 0.01%) of a single unit of the quote currency. That means you have to trade 10,000 units of the base currency to earn one unit of the quote for each pip of movement. The amount of the base currency you trade is known as your lot size.
To earn $1 for every pip that EUR/USD moves, for example, you’d have to trade the equivalent of €10,000.
Remember that a pip is worth 0.01 (or 1%) of the base currency when the quote is the yen? If you traded $10,000 of USD/JPY, you’d earn or lose ¥100 for each pip that USD/JPY moves.
If USD/JPY is trading at 110.00, then that’s the equivalent of $0.91 ((1 pip/110.00) x ($10,000)).
- USD/JPY is trading at 110.00
- You use $10,000 to buy ¥1,100,000 worth of USD/JPY
- USD/JPY moves up to 111.00
- You can now sell your $10,000 for ¥1,110,000, earning you a ¥10,000 profit
- Your buy position earns you ¥100 for every pip of upward movement
- USD/JPY has moved up 100 pips, earning you (¥100 x 100) ¥10,000 or (¥10,000/111.0) $90.01
- If USD/JPY had fallen to 100 pips, you would have made a ¥10,000 loss
Forex and leverage
As you’ve probably noticed, a pip doesn’t have much value in real terms. That’s why most individual traders use leverage to take advantage of the constant fluctuations in forex prices.
Leverage means you’re only required to put up a small amount of money (known as margin) to control a much larger amount. It enables retail traders to open short-term forex positions without locking away thousands of pounds’ worth of capital. However, it magnifies both your profits and your losses – so requires careful risk management.
We’ll cover leverage and risk in more detail in the Trading with leverage course.
Ways to trade forex
There are two main ways to trade currencies: spot FX and CFDs.
Spot FX is the method we’ve been covering so far – trading the quote currency for the base. CFD trading, meanwhile, works a little bit differently.
You’re still speculating on the price movements of currency pairs. But instead of buying and selling the quote and the base, you’re trading a contract that mirrors the price of the pair.
We’ll cover CFDs in more detail in the Trading with leverage course.
Currency pairs are traditionally divided into three groups related to their popularity and liquidity: majors, minors and exotics.
Majors are the most actively traded currencies, constituting about 85% of the total FX volume. They typically cost less to trade than minor currency pairs, because they are bought and sold so much.
The major pairs are:
- EUR/USD – the euro vs the US dollar
- USD/JPY – the US dollar vs the Japanese yen
- GBP/USD – British pound sterling vs the US dollar
- AUD/USD – the Australian dollar vs the US dollar
- USD/CHF – the US dollar vs the Swiss franc
- USD/CAD – the US dollar vs the Canadian dollar
EUR/USD, though, is the biggest by far – some 28% of all forex trades are on euro-dollar alone. The major currency pairs all include the US dollar (USD).
Euro vs US Dollar
US Dollar vs Japanese Yen
British Pound vs US Dollar
Australian Dollar vs US Dollar
US Dollar vs Swiss Franc
US Dollar vs Canadian Dollar
While the major currency pairs make up most of the market, you shouldn’t ignore the minors – also referred to as cross currency pairs. These are made up of all the other combinations of major markets, such as EUR/JPY, AUD/NZD and EUR/GBP.
Spreads for minor currency pairs are often wider because there are fewer people buying and selling them in the market at any given time.
Euro vs Japanese Yen
Australian Dollar vs New Zealand Dollar
Exotic currency pairs feature less popular currencies and are traded less frequently or in lower volumes. Due to these low volumes, exotics are illiquid and can be more expensive to trade. Many view exotic currency pairs as having higher risk profiles compared to commonly traded currencies.
Examples of exotic pairs include AUD/PLN, USD/CZK, GBP/DKK and EUR/TRY.
Australian Dollar vs Polish Zloty
US Dollar vs Czech Koruna
British Pound vs Danish Krone
Euro vs Turkish Lira
A good rule of thumb if you’re new to forex is to focus on one or two currency pairs. Generally, traders will choose to trade EUR/USD, USD/JPY or GBP/USD because there is so much information and resources available about the underlying economies involved.
What moves forex markets?
Lots of different factors can affect an individual currency pair’s price on any given day. Some common examples include:
Currencies tend to reflect the economic health of their parent nation. So critical economic data – such as inflation, unemployment numbers, foreign trade or payroll numbers – can often result in forex volatility.
Central banks can have a big influence over the performance of currencies, for example by changing interest rates or printing more money. They may also buy and sell their currency to keep it trading within a certain level.
Increasingly, political uncertainty can drive currency markets. The US dollar, for example, has traditionally been seen as a safe-haven currency – so its price may rise during troubled times.
Alternatively, something as banal as a speech by a finance minister can have a big impact on a currency.
We’ll cover forex price drivers in more detail in the Mastering forex course.
Making your first forex trade
Now you know a little more about forex, we can take a closer look at how to make your first trade. If you have a FOREX.com demo account, you can follow these steps to open a practice trade. If you haven’t, opening one takes seconds and costs nothing. Click here to open your forex demo.
Or if you’d like to try out trading on live markets, open a full account here.
1. Select a currency pair
Most new traders will focus one of the three headline majors – EUR/USD, USD/JPY and GBP/USD – but you can trade any currency pair that we have available as long as you have enough virtual funds in your demo.
Search for ‘EUR/USD’ in the demo platform.
2. Analyse the market
This is how you decide whether to go long or short, as well as what strategy to take. You might look at current and historical charts, monitor the news for economic announcements or consider applying a few technical indicators.
Take a look at recent news on EUR/USD. Are there any clues to its future price action?
We’ll take a closer look at technical and fundamental analysis later on.
3. Read the quote
Like most financial markets, forex pairs will have two prices listed on their quote.
The first is the price at which you can sell the currency pair. The second is the price at which you can buy the currency pair. The difference between them is called the spread, which is the amount that a dealer charges for making the trade.
Take a look at the EUR/USD trade ticket by clicking on its market name.
4. Pick your size and position
The size of your trade determines how much of the base currency you are buying or selling – and how much you’ll make or lose for each pip that the pair moves.
Choose a buy position if you believe that the value of the base currency will rise compared to the quote currency. Choose a sell position if you believe that the value of the base currency will fall compared to the quote currency.
Select a ‘buy trade’ with a quantity of 1000, and hit ‘Place trade’ to open your position.
5. Monitor and close your trade
To close a forex trade, you trade in the opposite direction to when you opened it. If you used a buy trade to open, you sell to close – and vice versa.
Go to your open positions, where you’ll be able to see your running profit or loss. When you’re ready to close your position, select EUR/USD and hit ‘close trade’ to sell €1000.
Test your knowledge
The Federal Reserve announces that it is raising interest rates. What might that mean for USD/JPY?
- A It will go up
- B It will go down
- C It will stay the same
- A It will go up
- B It will go down
- C It will stay the same