Forex Basics

Let's start learning forex basics by answering some simple questions.

Forex Basic #1: What is Forex?

The word forex stands for Foreign Exchange Market. It is also referred to as retail forex, FX and/or spot forex. Forex is the largest financial market in the world. At 4 trillion dollars per day, its daily trading volume is over 3 times greater than that of the stock market and futures market combined.

To put it simply, money (currency) is traded on the foreign exchage market as opposed to shares of a company's stock. Currencies are traded in pairs, so in order to make a forex trade you must simultaneously buy one currency while selling another currency.

For example, if you wanted to trade the euro, one way to do this would be to trade the euro and US dollar pair (EUR/USD). If you expect the euro to increase in value with respect to the US dollar, you would buy a quantity of euros while simultaneously selling a quantity of US dollars of equal value.

Since in this case you are exchanging dollars for euros, you would make money on the trade if the exchange rate between these 2 currencies changed in your favor. Let's look at an example using one full lot for easy calculation purposes.

If you think that the EUR will rise in value relative to the USD you would buy one lot (100,000 units) of the EUR/USD currency pair.

Let's say the EUR/USD is trading at an exchange rate of 1.3250 when you buy the lot. That means that you can buy 1 EUR for each $1.3250 USD you spend.

When you later go to sell the lot, the euro is trading at an exchange rate of 1.3370. That means you will now get back $1.3370 USD for each EUR you sell.

You bought euros at 1.3250 and sold them at 1.3370 for a profit of .0120 or 120 pips.

For a full lot, each pip is worth $10.

So, 120 pips x $10 = $1,200 profit.

The same scenario would be true for selling the EUR short if you think its value will fall with respect to the value of the USD.

Keep in mind that while this is an example of a profitable trade, if the exchange rate had gone the opposite way during this trade, money would have been lost.

Forex Basic #2: What is a Pip?

Since the unit of profit/loss for our trade example was the pip, the next forex basic we'll need to know is: What is a pip? The word pip is derived from the term Percentage In Point, and is the smallest price increment in forex trading.

Forex prices are quoted to the fourth decimal place for most currency pairs, and a change in that fourth decimal place represents 1 pip. For example, the difference between EUR/USD at 1.3200 and 1.3205 is 5 pips.

An example of a currency that doesn't follow this general rule is the Japanese Yen (JPY). It is quoted only to the second decimal place. In this case, a change in the second decimal place represents 1 pip.

Forex Basic #3: What is a Lot?

Another basic term that you need to understand is the lot. Unlike stocks which are traded in shares, forex trades in units and these units are grouped together to form lots. A standard lot consists of $100,000 worth of a currency, and a "mini" lot consists of $10,000 worth.

When choosing a broker to start out with, make sure that they allow at least "mini" lot trading, and preferably "micro" lot trading as well. "Micro" lots are lot sizes that consist of less than $10,000 worth of currency.

I use Oanda as my broker because they offer "micro" lot sizes which fits my style of trading and money management. I can select any number of units to trade that I want without being restricted to full lot sizes. If I want to place a trade where a 1 pip movement is worth $5.00 ($5 per pip) then I can calculate how many units (lot size) of that particular currency pair I need to trade to attain that goal.

Here's the calculation I use to determine the lot size I want to trade (this works for pairs that are quoted to the fourth decimal place):

Lot size = (Desired price per pip) / (.0001 / price of currency)

Therefore, to calculate the lot size for a EUR/USD trade that will yield $5 per pip with the price of the EUR/USD at 1.3200, plug the numbers into the equation above:

Lot size = 5 / (.0001/1.3200)

The result yields a lot size of 66,000 units to trade at $5.00 per pip for this trade.

You can use this equation to calculate your lot size for currencies like the yen that are quoted only 2 decimal places out:

Lot size = (Desired price per pip) / (.01 / price of currency)

To calculate the lot size for a USD/JPY trade that will yield $5 per pip with the price of the USD/JPY at 99.50, plug in the numbers:

Lot size = 5 / (.01/99.50)

The result yields a lot size of 49,750 units to trade at $5.00 per pip for this trade.

Forex Basic #4: Which Currencies Can Be Traded?

Another forex basic question is: Which currencies can be traded on the spot forex market? Here is a list of the most popular currencies to trade (the majors). Each one is paired with several of the others to make up the list of currency pairs we can trade: