The word FOREX is derived from the term Foreign Exchange and is the largest financial market in the world. Unlike many other markets the FX market is open 24 hoursa day and has an estimated $1.2 Trillion in turnover every day. Thistremendous turnover is more than the combined turnover of the mainworlds’ stock markets on any given day. This tends to create a very liquid market and thus a very desirable market to trade.
Unlike many other securities, (any financial instrument that can be traded) the FX market does not have a fixed exchange. It is primarily traded through banks, brokers, dealers, financial institutions and private individuals.
Trades are executed through telephonic communications and now increasingly through the Internet. It is only in the last few years that the smaller investor has been able to gain access to this market. Previously the large deposits t
hat were required precluded the smaller investors but with the advent of the Internet and growing
competition, it is now easily within reach of most investors.
‘INTER’ meaning between and ‘Bank’meaning any deposit taking institution. The market has moved on to such a degree that now the term interbank means anybody who is prepared to buy or sell a currency.
It could be just two individuals changing currencies or your local travel agent offering to exchange Euros for US Dollars. You will however find that most of the brokers and banks use centralized feeds to insure reliability of quote.
The quotes for Bid (buy) and Offer (sell) will all be from reliable sources. These quotes are normallymade up of the top 300 or so large institutions. This ensures that if they place an order on your behalf, the institutions they have placed the order with will be capable of fulfilling the order.
Now although we have spoken about orders being fulfilled, it is estimated that anywhere from 70%-90% of the FX market is speculative. In other words the person or institution that bought or sold the currency has no intention of
actually taking delivery of the currency. Instead they were solely speculating on the movement of that particular currency.
Market Mechanics
So now we know that the FX marketis the largest inthe world. Your broker or the institution that you aretrading with is collecting quotes from a centralized feed and/or individual quotes comprising of interbank rates.
So how are these quotes made up? Well, as we previously mentioned, currenciesare traded in pairs anare each assigned a symbol. For the Japanese Yen it is JPY, for the Pounds Sterling it is GBP, for Euro it is EUR and for the Swiss Frank it is CHF. So, EUR/USD would be the Euro-Dollar pair. GBP/USD would be the Pounds Sterling-Dollar pair and USD/CHF would be the Dollar-Swiss Franc pair and so on.
You will always see the USD quoted first aside for a few exceptions such as Pounds Sterling, Euro Dollar, Australia Dollar and New Zealand Dollar. The first currency quoted is called the base currency. Have a look below for some examples.
Currency Symbol Currency Pair
EUR/USD
GBP/USD
USD/JPY
USD/CHF
USD/CAD
AUD/USD
NZD/USD
Euro / US Dollar
Pounds Sterling/ US Dollar
US Dollar / Japanese Yen
US Dollar / Swiss Franc
US Dollar / Canadian Dollar
Australian Dollar / US Dollar
New Zealand Dollar / US Dollar
When you see FX quotes you will actually see two numbers. The first number is called the bid and the second number is called the offer (sometimes called the ASK).
If we use the EUR/USD as an example you might see 0.9950/0.9955. The first number 0.9950 is the bid pri
ce and is the price traders are prepared to buy Euros against the USD Dollar. The second number 0.9955 is the offer price and is the price traders are prepared to sell the Euro against the US Dollar.
These quotes are sometimes abbreviated to the last two digits of the currency e.g.: 50/55. Each broker has their own convention and some will quote the full number and otherswill show only the last two.
You will also notice that there isa difference between the bid and the offer price which is called the spread. For the four major currencies the spread is normally 5, give or take a pip (I’ll explain pips later)
To carry on from the symbol conventions and using our previous EUR quote of 0.9950 bid, this means that 1 Euro = 0.9950 US Dollars. For another example, if we used the USD/CAD 1.4500, that would mean that 1 US Dollar = 1.4500 Canadian Dollars.
The most common increment of currencies is the PIP. If the EUR/USD moves from 0.9550 to 0.9551 that is one pip. A pip is the last decimal place of a quotation. The pip or POINT as it is sometimes referred to, depending on context, is how we will measure our profit or loss.
As each currency has its own value, it is necessary to calculate the value of a pip for that particular currency. We also want a constant, so we will assume that we want to convert everything to US Dollars. In currencies where the US Dollar is quoted first the calculation would be as follows.
Example: the JPY rate of 116.73 (notice the JPY only goes to two decimal places, most of the other currencies have four decimal places)
In the case of the JPY 1 pip would be .01 therefore
USD/JPY: (.01 divided by exchange rate = pip value) so .01/116.73=0.0000856. It looks like a big number but later we will discuss lot (contract) size later.
USD/CHF: (.0001 divided by exchange rate = pip value) so .0001/1.4840 = 0.0000673
USD/CAD: (.0001 divided by exchange rate = pip value) so .0001/1.5223 = 0.0001522
In the case where the US Dollar is not quoted first and we want to get to the US Dollar value we have to add one more step.
EUR/USD: (0.0001 divided by exchange rate = pip value) so .0001/0.9887 = EUR 0.0001011 but we want to get back to US Dollars so we add
another little calculation which is EUR X Exchange rate so 0.0001011 X 0.9887 = 0.0000999 wh
en rounded up it would be 0.0001.
GBP/USD: (0.0001 divided by exchange rate = pip value) so 0.0001/1.5506 =
GBP 0.0000644 but we want to get back to US Dollars so we add another little calculation which is GBP X Exchange rate so
0.0000644 X 1.5506 = 0.0000998 when rounded up it would be 0.0001.
By this time you might be rolling your eyes back and thinking ‘do I really need to work all this out?’, and the answer is no.
Nearly all the brokers you will deal withwill work all this out for you. They may have slightly differentconventions, but it’s all done automatically. It’s good however for you to know how they work it out. In the next section we will be
discussing how these seemingly insignificant amounts can add up.
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