The foreign exchange market, or forex market, has its own set of terms and jargon that may be difficult for beginners to understand. Before going deeper into trading the forex market, all beginners must learn the terms discussed in this guide.
Being familiar with the most important and commonly-used terms in forex trading will form a fundamental knowledge base that traders can refer to. It is important to know these terms as beginners will know what they refer to, what they mean, and what actions must be taken.
These terms are easy to learn, and as beginners start entering the forex market by using a demo account, they will see how these terms come into play in forex trading. While knowing these terms will not bring success in forex trading, it can help beginners avoid obvious mistakes and help to direct their trading decisions because they know what these terms mean.
1. Exchange Rate
An exchange rate can simply be defined as the value of one currency of a nation in comparison with that of another nation or an economic zone.
For example: How many US dollars does it take to buy one British Pound? At the time of writing, on August 17, the exchange rate between GBP/USD is 1.39, which means that it takes $1.39 to buy £1.
In terms of its frequent use, the exchange rate is a factor that must always be considered in every forex trade, and forex traders must know the exchange rates of the currency pairs that they trade.
In terms of importance, traders must know what the exchange rates are as it will determine how much traders will pay in the base currency to obtain units in the quoted currency.
In terms of how exchange rates are used, a real-world example can be given as follows:
Jack is traveling to London from his home in Texas, and he wants to ensure that he has at least 200 US dollars’ worth of pounds when he arrives in Germany. Jack goes to a local currency exchange shop, and he sees that the currency exchange rate between USD and GBP is 1.39, which means that if he exchanges $200, he will receive £143.88 in return.
The equation for conversion is either US Dollars ÷ exchange rate = British pound, or $200 ÷ 1.93 = £143.88.
Jack has returned to the United States from his London trip, and he now wishes to exchange his pounds for dollars as he never used the £143.88. On the day that he went to do the exchange, the rate fell to 1.20. Jack exchanges his £143.88, and because the rate fell, he only receives $172.65.
In this case, the equation to convert the Pound to the dollar would entail the reverse, where pounds x the exchange rate = US dollars or £143.88 x 1.20 = $172.65.
2. Base currency
In the foreign exchange market, or the forex market, all currency unit prices are quoted as a currency pair. The base currency is also known as the transaction currency, and it is the first currency that appears in a currency pair quote, followed by the quote, or counter, currency.
The base currency is also known as local or domestic currency, and it is often used by firms to represent profits and losses. In forex, the base currency represents how much of the quote currency the trader needs to get one unit of the base currency.
For example, when considering the GBP/USD currency pair, the Great British Pound would be the base currency, whereas the US Dollar would be the quote currency.
The frequency of use in forex will be a constant as forex is quoted in pairs consisting of a base currency and a quote currency.
In terms of the benefits of knowing the term, forex traders will easily remember this term as they will use it every time that they trade forex.
3. Currency pair
A currency pair in forex trading is the quotation of two different currencies where the value of one is being quoted against that of another. The first currency in the pair is called the base currency, followed by the quote currency.
Currency pairs serve the function of comparing the value of one currency to another or the base currency versus the quote currency. Currency pairs indicate how much quote currency traders need to purchase a single unit of the base currency.
Currencies are typically identified by their ISO currency code, which is a three-letter alphabetic code that they are associated with on international markets. For instance, the US Dollar is USD. Euro is EUR. Great British Pound is GBP, Japanese yen is JPY, and so on.
The asking price refers to the price that the broker will sell the base currency in exchange for the quote currency.
It is beneficial that traders not only know what a currency pair is but what role it plays in the forex market and how currencies are traded.
4. Long position (buy)
The term long position can be defined as what a trader has purchased when they have bought security and expect it to rise in value. Traders can establish a long position across several asset classes, including stocks, mutual funds, options, futures, and currencies.
When traders hold a long position, it is considered a “bullish view” because the trader feels that their financial instrument will appreciate.
In terms of frequency of use in forex, it will depend on the trading strategy of the trader. However, to trade in forex, traders must buy currency pairs to sell them for a profit. Having a “long” position in forex means that the trader owns the security.
The benefits of knowing this term and understanding how it works will mean that traders can effectively plan their trading strategy and their entry points into the forex market better.
5. Short position (sell)
Going short, short-selling, or taking a short position simply means that a forex trader is betting against the market. When traders are short, they are selling a currency pair assuming that its value would decrease, and the more the value decreases, the greater the profits that the trader makes.
When traders open a short position, they typically do so in a bearish market while they typically open a long position in a bullish market.
In terms of its use in forex, shorting is an inherent part of forex trading because, in trading forex, traders will always go long on one currency while they are simultaneously selling another.
The frequency of use of this term will be every time a forex trader buys a forex pair intending to sell it for a profit. When traders trade in the forex market, they make a bet that one of the two currencies will appreciate relative to the other, or vice versa.
When traders are short on a currency, they believe that the base currency will weaken against the quote currency.
The benefit of knowing this term is that traders can develop solid trading strategies because they understand what it is to go long and short in currencies. In other words, they know their entry and exit points.
An example of a short position in forex is as follows:
A forex trader goes short on EUR/USD because they believe that the Euro is about to depreciate relative to the US Dollar, which means that it would cost a few dollars to buy one Euro. In doing so, the trader will sell the Euros that they have, expecting that they will decrease in value.
Forex traders are quoted the price as a bid and as an offer or a sell and buy. In this scenario, the trader opens a short position for the selling price that they are given in the hopes that the value of the pair will fall, and if this happens, the trader will make a profit.
6. Ask price
Simply defined, the asking price is the minimum price that the seller or broker is willing to take for security.
The asking price is the amount of quoted currency that is needed to buy one unit of the base currency. The bid price will always be less than the asking price.
7. Bid price
The bid price represents the highest price that the buyer or forex trader is willing to pay for a security. The bid is typically lower than the offered or “Ask” price, which refers to the price at which others are willing to sell. The difference between the bid and ask price is referred to as the bid-ask spread.
Buyers can also provide a bid even if the seller is not trying to sell, and this is referred to as an unsolicited bid.
The benefits of knowing what the bid price is and how it is used in forex are crucial because forex traders will come across it during every trading day, with every deal executed. It is important to understand to ensure that traders can trade forex and know whether they are getting a good deal on a currency pair because the price can be negotiated between seller and buyer.
Depreciation, also known as devaluation, can be described as a decrease in the value of one currency when it is compared to specific patterns such as the high price of gold or foreign currencies.
Currencies can depreciate for several reasons, such as a lack of confidence in the economy of a certain country, a deficit of trade balance, when a central bank or monetary authority gives new value for a currency, and so on.
There are many driving factors behind price movements in the forex market, and the economic, political, and other factors, behind the value of a currency, is important to understand as it will help to direct the decisions that traders make, which currencies they buy when they sell, and so on.
The word “pips” is the abbreviation for “Percentage in point” or “price interest point.” A pip represents a small measure of changes in a currency pair in the forex market. Pips can be measured according to the quote or in terms of the underlying currency.
Pips are standardized units, and it is considered the smallest amount that a currency quote could change. Pips also refer to the fourth decimal change point of a price which is equal to 1/100th of 1%.
The standardized size of a pip helps to protect traders from significant losses in the financial markets. For example, if one pip was ten basis points, a one-pip difference would cause significant volatility in currency values.
An example of the place that pips have in forex trading is as follows:
The spread is the difference between the bid/ask price, and a trader buys USD/EUR, which has a spread of 0.7747 pips, which means that for $1, the trader can buy 0.7747 Euro. If there is a one-pip increase in this quote, the value of the US Dollar would subsequently rise relative to the Euro as the $1 would allow the forex trader to buy more Euro.
If the trader proceeds to buy 10,000 euro with US dollars, the price that they would have paid would be $12,908.22, with the equation that 1 ÷ 0.7747 x 10,000 = $12,908.22. If there is a one-pip increase in the exchange rate for EUR/USD, the price paid would be $12,906.56, or 1÷ 0.7748 x 10,000, as the change would occur in the fourth decimal of the quote, with 0.7747 increasing to 0.7748.
Gapping is something that occurs when the price of a currency, or any other security or asset, opens either above or below the price at which it closed the previous day, with no trading activity in between.
The gap is the area of discontinuity on the price chart of security, and they can materialize if there are headlines that cause the fundamentals of the market to change rapidly, especially during hours when the financial markets are often closed, for instance when there were earnings calls after-hours over a weekend, or on a public holiday.
In terms of the benefits of knowing what gapping is and how it works, traders can ensure that they plan their trades more efficiently for when the markets open. Traders can also protect themselves against high volatility in the forex market because of gapping, especially traders who keep positions open over times when the forex market is closed.
There are three different types of gapping that traders must familiarize themselves with and ensure that they understand:
- Common gaps – which occur often and which have little significance. These are gaps where the opening price differs slightly from the prior closing price.
- Breakaway gaps – these occur when the price moves above a significant resistance area or when it moves below the support area on the gap.
- Runaway gaps occur when there is a strong trend, and they indicate that the trend remains strong enough to cause a gap in the trend direction.
The simplest definition of a lot is that it is the smallest available position size that traders can place when they trade forex. This is the number of currency units that the trader will buy or sell, and it can be divided into four different lot sizes, namely:
Standard lots are the most frequently used position size in forex, and it is the volume of 100,000 units. When traders buy or sell 1 lot of a forex pair, they are buying or selling 100,000 units of the base currency.
Mini lots are equal to 10% of a standard lot, which means that they represent 10,000 units. If traders buy 1 lot of a forex pair, it means that they purchase 10,000 units of the base currency.
Micro Lots are one of the smallest tradable lots in forex that represent 1,000 units. If traders buy 1 micro lot of a forex pair, they will purchase 1,000 units of the base currency.
Lastly, Nano lots are the smallest position size available, and they represent 100 units, which means that 1 nano lot is equal to 100 units of the base currency.
In terms of the frequency and use in forex, lot sizes are used with every forex transaction, and it is beneficial that traders understand the term as they will have to set and adjust their position sizes. Many brokers offer traders the use of a position size calculator that makes it easy to calculate lot sizes.
When beginners start their trading journey in forex, one of the best ways to mitigate and manage risk is to ensure that they start trading smaller positions, strategically making them larger as they grow more confident and gain more trading experience.
Currency appreciation is when the value of one currency increases relative to the other currency in the pair. Currencies can appreciate against one another for several reasons, including the government policy, interest rates, business cycles, trade balances, and several other reasons.
Where there is a floating-rate exchange system, a currency’s value will consistently change according to supply and demand in the forex market. This fluctuation in values subsequently allows forex traders to increase or decrease the holdings that they have, allowing for them to profit.
In terms of the use of forex, it is important to remember that currencies are traded in pairs, and this means that currencies appreciate when the value of one goes up in comparison to the other currency in the pair.
Forex traders typically trade a currency pair believing that the base currency will appreciate against the counter currency.
In terms of frequency of use, this term will always be a factor even if traders do not encounter the term directly. Appreciation of currencies is a driving force behind why traders trade in forex.
The benefits of knowing the term and understanding how it works will help traders direct their trading decisions. Traders must realize the link between appreciation and demand. If the value of a currency appreciates, the demand for that currency will also rise.
Leverage refers to the process of borrowing money to invest in a forex pair. Traders borrow capital from their forex broker to allow them to trade much larger positions despite the size of their initial deposit. As a result, leverage magnifies the returns that traders can get from favorable movements in the exchange rate of the currency pair that they are trading.
However, leverage can be a double-edged sword, meaning that where profits are magnified, so are the losses that traders can incur when the movements in the exchange rate move against them.
For example, a trader buys $100,000 worth of the EUR/USD currency pair, the trader may be required by the broker to hold $1,000 in the trading account as margin, or collateral for the trade, which means that the margin requirement is 1%, or $1,000/$100,000.
The leverage ratio shows how much the position size was magnified because of the margin that is held by the broker. When considering the margin example given above, the leverage ratio for the trade would be equal to 100:1, or $100,000/$1,000.
This means that with an initial deposit of $1,000, the forex trader can trade a position size of $100,000 on a specific currency pair.
Some of the most typical margin requirements and leverage ratios are:
- 2% – 50:1
- 1% – 100:1
- .5% – 200:1
This means that the lower the margin requirement, the greater the amount of forex that can be used on a trade. Margin requirements can be according to the discretion of the broker, and some may have higher margin requirements for certain forex pairs.
In terms of frequency of use, traders will come across the term “leverage” in every trade that they execute with a forex broker. Forex traders are not obligated to use leverage when they trade, but it helps them open larger positions and increase their chances of earning greater profits.
The benefits of knowing what the term “leverage” means and understanding how it works will help traders plan their trades better, knowing when to use leverage and how much to use.
14. Risk management
Risk management can be defined as the process where forex traders identify potential risks in their trading plan and strategies and taking the necessary steps to eliminate, mitigate, or manage them to prevent losses or minimizing the losses that can be incurred.
- Making sure that position sizes are correct
- Setting up stop-losses
- Controlling emotions when entering and exiting a trade, and more
The benefits of understanding what risk management means and what it entails will ensure that traders can trade profitably while they minimize their risk of loss.
In terms of frequency of use, traders must use risk management with every trade that they execute, and it must form a fundamental and crucial part of their trading plan and trading strategies. Traders must never risk more than they can afford to lose, and they must understand trading psychology to prevent human, emotional factors from becoming a risk to their trade and capital.
To use risk management effectively in forex trading, traders must understand these fundamentals:
- Risk appetite – which means that traders determine how much they are willing to lose in a trade, evaluating their willingness to be exposed to risk and whether they have the means to recover from a loss. Traders must not risk more than 1% to 3% of their account balance per trade.
- Position size – by selecting the correct position size or number of lots, traders can protect their accounts while maximizing their opportunities to make a profit. Traders must calculate their stop placement, determine their risk percentage, and evaluate their pip cost as well as lot size. Alternatively, traders can use an online position size calculator.
- Stop Losses – these are placed so that trade is closed automatically once a specific price has been reached. Traders are urged to use stops and limits to enforce a risk-reward ratio of 1:1.
- Leverage – traders must manage their leverage carefully to ensure that they do not incur a significant loss that might deplete their trading account.
- Control emotions – this is an important factor that traders must never neglect. Traders must prevent excitement, greed, fear, or boredom from directing their trading decisions. If traders feel that their emotions may be a risk factor, they are urged to step away from their trading until they can control their emotions.
A stop-loss or SL can be defined as an order that traders place on their trade to limit the losses on an open position or a trade. Stop-loss levels are considered one of the most effective risk management tools that traders must use for every trade.
The benefit of knowing this term and understanding how a stop loss works is that traders can limit their losses more effectively.
In terms of how stop losses are used, for example, the trader placed a Buy order on EUR/USD at 1.385, and they have set their stop loss at 1.375, which means that if the price moves below the trader’s entry and it hits 1.375, the order will be closed automatically, and the trader would have a loss of 10 pips.
When traders enter a long (buy) position, their stop loss will be placed below their entry price, with a take profit placed above the entry price. If the price on the currency pair falls and it hits the stop loss, traders will make a loss. If the price increases and hits the take profit, traders will make a profit.
When traders enter a short (sell) position, the stop loss will be placed above the entry price, and the take profit will be placed below the entry price. If the price of the currency pair increases and hits the stop loss, traders will make a loss, and if the price decreases and hits the take profit, the trader will earn a profit.
16. Take profit
Simply defined, a take profit (TP) is an order that is placed by the trader to close a position at an exact price for a profit. The take profit is used in conjunction with the stop loss, and they reduce the chance of any significant moves against a winning position by closing the position once the profit target is reached.
In terms of frequency of use, take profits must be placed at the start of every trade so that traders can protect themselves against any significant price movements that may occur.
In terms of the benefits of knowing what a take profit is and how to use it, traders can plan their entries and exits more efficiently to ensure that they are protected from loss while they still earn profits from their trades.
In terms of how a take profit is used, traders set their take profit levels when they open a position. To determine where traders must place their SL and TP, they conduct a technical analysis using horizontal support/resistance, and trendlines which will determine the price at which the forex market may stall or reverse against the favor of the trader.
Traders then place their TP at the right level above their entry price when they go long or below their entry price if they go short. Once the price reaches the TP level, the trade will automatically close.
Take profit levels to ensure that traders lock in potential gains before the market moves in the opposite direction, taking the profits that the trader has made with it.
Simply defined, Profit/Loss refers to a ratio and the size of the average profit, which is compared to the size of the average loss per trade. Alternatively, profits refer to gains, whereas loss refers to capital that the trader has lost because of markets moving against them.
In terms of frequency of use, traders will be exposed to profits and losses with every single trade unless they break even, and they did not make a profit or incurred a loss.
The benefits of knowing what profits and loss mean, along with the profit/loss ratio, give traders an idea of what they can expect when they trade forex.
When traders trade in forex, they are often told of a money management strategy. This strategy dictates that the average profits be more than average losses per trade. For example, if the trader’s expected profit is $900 and they expect a loss of $300, it means that their profit/loss ratio is 3:1.
Most professionals in the industry recommend that traders have a profit/loss ratio of either 2:1 or 3:1, which means that for each $200 or $300 the trader makes per trade, there is a potential loss of $100.
Traders must calculate their profit and loss for each trade. To calculate this, traders need their position size and the number of pips that the price has moved. Therefore, the actual profit/loss will be equal to the position size x the pip movement.
For example, a trader has a standard lot (or 100,000) GBP/USD position that is trading at 1.3147. If the price moves from 1.3147 to 1.3162, it shows a price movement of 15 pips. Thus, for a 100,000 GBP/USD position, the 15-pip movement indicates a movement of $150.
To determine whether that $150 was a profit or a loss, it will depend on whether the trader entered a long position or a short position on the trade.
In terms of a long position, if the prices increase, it will mean that the trader makes a profit, and if the prices go down, it will be a loss. Using the same example as above, the $150 would be a profit to the trader if the prices had moved up. If the prices had moved down from GBP/USD 1.3147 to 1.3127, the trader would have experienced a $200 loss.
In terms of a short position, if the prices increase, it will be a loss for the trader, whereas if the prices move down, it will be a profit. Using the same example as above, if the trader had a short position on GBP/USD and the prices moved up by 15 pips, they would have incurred a $150 loss. However, if the prices had moved down by 20 pips, the trader would have made a profit of $200.
18. Quote currency
In forex trading, the quote currency is also known as the counter currency. It is the second currency that is found in a forex pair, and it is used to determine the value of the base currency.
In terms of frequency of use, the quote currency is a term that will be used in every forex pair because forex is traded in currency pairs that consist of a base and quote currency.
The benefits of knowing what the term means and how it is used will help traders navigate the markets. It is a term that is easy to learn and understand because traders will constantly interact with the term in the forex market.
Forex arbitrage can be defined as a strategy that involves exploiting the price disparity that exists in the forex markets. This can be affected in several ways, but despite how it is done, arbitrage seeks to buy currency prices and sell currency prices that are divergent but likely to rapidly converge.
In terms of frequency of use, this term forms part of several others when traders start exploring forex trading signals.
In terms of the benefit of knowing what arbitrage means and how it works, traders can explore this trading strategy and apply it in the forex market.
In terms of how it is used, several different types of arbitrage can be used. However, the principle remains the same, traders buy currencies that are undervalued against currencies that are overvalued, and they try to make profits from corrections in the forex market.
For example, a trader has EUR/JPY, which was quoted at 122.500 by a bank based in London, while it was quoted at 122.450 by a bank based in Tokyo. The trader who has access to both quotes can enter a long position on the London price, and they can enter a short position on the Tokyo price.
If the price on EUR/JPY converges at 122.550, the trader closes both their trades. The Tokyo position would have incurred a loss of 1 pip while the London position would have gained 5, which means that the trader made a profit of 4 pips, fewer transaction costs.
Some of the most common types of forex arbitrage include:
- Currency Arbitrage – which involves the exploiting of differences in quotes instead of movements in the exchange rates of currencies in the forex pair.
- Cross-Currency Arbitrage – which aims to exploit pricing between currency pairs or the cross rates of different currency pairs, such as in the example given above.
- Covered Interest Rate Arbitrages – which involves the practice of using favorable interest rate differentials, allowing traders to invest in higher-yielding currencies in addition to hedging the exchange risk by entering a forward currency contract.
- An Uncovered Interest Rate Arbitrage, which involves the trader changing their domestic currency with a lower interest rate to a foreign currency that offers a much higher rate of interest.
- Spot-Future Arbitrage – when the trader opens a position in the same currency in both the spot and futures markets.
20. Margin Call
Simply defined, a margin call is an occurrence where traders no longer have any usable or free margin, or simply put, their trading account needs more funding. Margin refers to the minimum amount of capital that is required to place a leveraged trade, and leverage is a tool that provides traders with greater exposure without having to put down the full amount of the trade.
In terms of the benefits of knowing what margin call is and understanding what it means, it ensures that traders will avoid encountering a margin call, and traders will learn how to size their positions correctly to avoid it, allowing them to mitigate and manage their risk more effectively.
Margin calls are likely to occur when traders commit to a large position without leaving enough capital in their trading account to absorb losses that they incur. Margin calls are typically caused by the following factors:
- When traders hold a position too long, depleting their usable margin.
- Using too much leverage in combination with holding the position for too long.
- Trading with an account that does not have enough capital, forcing the trader to overtrade with too little usable margin.
- Trading without using stop-losses and having the price move aggressively in the opposite direction.
When a margin call occurs, the trader will be liquidated from their position, or their position will automatically be closed. The purpose of this is two-fold, the trader no longer has enough capital in their trading account to hold the losing positions, and the broker is on the line for the loss, which also spells bad news for the broker.
To avoid a margin call, traders must remember that leverage has positive and negative impacts. The larger ratio the trader uses, relative to the capital deposited, the less usable market they will have to absorb losses incurred. This is also magnified if the over-leveraged trade moves against the trader, depleting their trading account faster.
To avoid margin calls when trading forex, traders can use these tips:
- Traders are urged to use leverage with extreme caution despite the potential gains that they could make. It is better to make smaller profits consistently than to lose it all on one big trade.
- Traders must ensure that they have robust and solid risk management and that they always use stop losses in every trade to limit the loss that they can incur.
- Traders are urged to ensure that they keep a healthy amount of free margin on their accounts so that they can keep their positions open. Traders are urged to use no more than 1% of their account equity and no more than 5% on all trades at any given point.
- Traders are also urged to reduce their position sizes and to approach every trade as one of a thousand insignificant and little trades. Traders can easily make use of position calculators that are typically provided by brokers and many forex websites to help them determine the right position size relative to their available capital.