There are certain basic rules or conditions that one needs to know before one can start trading Forex.
These include certain terminology and understanding certain concepts:
The value of one currency in relation to another is termed as the exchange rate. For instance, how many U.S. dollars would you have to pay to buy 2,50,000 chinese Yuan? This relative value is expressed in terms of the exchange rate.
Thus, we will say that 1 U.S. dollar is equal to 6.852 Chinese Yuan (CYN). The exchange rate therefore is 6.852. Which means you would have to pay CYN 6.852 per USD 1. This is quoted as ‘USD/CYN exchange rate is 6.852’ or USDCYN exchange rate is 6.852.
Exchange rate is determined and controlled by various factors, all of which are impossible to list and understand here.
Base Currency / Quote Currency
Exchange rates are always quoted as number of units of one currency (called quote currency) that can be exchanged for one unit of another currency (called base currency). In the above case, USD is the base currency, and CYN is the quote currency. The quote currency is written second in the pair.
Base currencies are usually decided by market trends. Usually, these are currencies belonging to countries with strong economic and industrial development. The current convention follows this order: EUR – GBP – AUD – NZD – USD – others, with the currencies on the left acting as base currencies for the other currencies, when in a pair.
Thus in a conversion from AUD to USD, AUD is the base currency. However, if both the currencies fall into the ‘other’ category, the convention is to use any other currency that gives an exchange value greater than one.
Price Interest Point - Pip
Exchange rates are given in decimal form. For instance, EUR/USD = 1.432. The smallest unit of this decimal number is called Percent Interest Point or ‘pip’. Exchange rates fluctuate in terms of pips. For instance, if the interest rate fluctuates from 1.432 to 1.438, that’s a change of 6 pips.
There is usually a difference of few pips in the Bid price (selling price) and Ask price (buying price) of a currency. The profit or loss that you make while trading is calculated on the basis of those few pips.
Forex Market / Spot FX
There are many ways of buying and selling currency on the FX market, however, when we talk of retail trading which you and I can indulge in, we are talking of Spot Trading. Spot Trading or Spot FX is buying and selling currencies ‘on-the-spot’ as opposed to entering into a contract by which a certain transaction will be made on a future date.
Maximum transactions in foreign exchange happen in the spot FX market. When you trade spot FX, the transaction is completed within 2 days from the day the deal is struck (or one day in the case of certain currencies).
With spot trading, you can take advantage of the fluctuating exchange rate when it is in your favour and make huge profits. However, if you’re not able to keep track of the rate, it will also mean large losses.