Although it might seem complicated at first, the art of trading currencies is actually quite simple.
When you trade currency pairs, you are basically buying or selling one currency for the other. If you decide to buy a particular pair, you are hoping that the market will appreciate, while if you sell a pair, you will want the opposite to happen.
Each currency pair has two prices – one for selling (known as the ‘ask’ price) and one for buying (or ‘bid’ price). The difference between these two values is called the ‘spread’, and signifies how much a broker will charge to open the trading position. A basic rule of thumb is that the more times a currency pair is traded, the narrower the spread will be.
Trading quotes will usually be presented to four decimal places, for example 1.2345. If you decide to trade a particular currency pair, for instance GBP/USD, you will need to invest 1.2345 USD for each GBP you want to buy.
If there is a change in a currency’s value, it will most likely be seen at the fourth decimal place, known as the pip. The spreads, gains and losses of a trade are usually displayed as pips.
To place a trade, you will first of all check the ask and bid prices, and select whether you want to buy or sell a currency pair. The next thing will be to select the number of units you wish to trade. If you have correctly predicted the way the market will go, you will make a profit from this trading position.
Applying leverage to a trade lets you open larger positions than your initial investment would otherwise allow. For example, if a trading position has a leverage of 200:1, you will need to invest $1 for every $200 wagered.
If you therefore wish to buy 5,000 units of GBP/USD at a price of 1.2345, instead of paying $6,172.50 you will only be charged $30.86. This represents 0.50% of the original price, or a 200:1 ratio.
Traders use leverage to increase their profit by only wagering small amounts of their own capital. However, it is worth pointing out that it can also magnify your losses if the markets move the opposite way to what you have predicted.
As you go through your trading career, you are likely to hear a lot about ‘bullish’ and ‘bearish’ markets. These terms are used to describe whether a currency pair is in an upward or downward trend. A bull market is on the rise, while a bear market is on the decline.
The same terminology can also be used to describe traders themselves. If you are somebody who likes to speculate and attack the markets, you are a bull trader. On the other hand, if you are more defensive, you are known as a bear trader.
Currency pairs are divided into three categories – majors, minors and exotics. Major pairs always involve the USD as either the base or counter currency. Some examples include EUR/USD, USD/NZD and GBP/USD.
The minor pairs are when the major currencies excluding the USD (JPY, GBP, EUR, CAD, AUD, CHF and NZD) are traded against each other. Examples of minor pairs include GBP/JPY and AUD/CAD.
An exotic pair involves trading one major currency and one minor currency, such as USD/NOK and EUR/TRY.