When you open a forex position, you are buying one currency while simultaneously selling another. Read on to learn about forex trading basics and how a forex trade works: including currency pairs, the spread, pips and leverage.
What are currency pairs
Forex trading always involves selling one currency in order to buy another. For this reason, they are quoted in pairs that show which currency is being bought and which is being sold. Each currency in the pair is listed in the form of its three letter code, which tends to be formed of two letters that stand for the region, and one standing for the currency itself.
GBP/USD, for instance, is a currency pair that involves the Great British pound and the US dollar. In this pair, you are buying pound sterling by selling US dollars.
Base and quote currency
The first currency listed in a forex pair is called the base currency, and the second currency is called the quote currency. The price of a forex pair is how much one unit of the base currency is worth in the quote currency.
So in the above example, GBP is the base currency and USD is the quote currency. If GBP/USD is trading at 1.35361, then one pound is worth 1.35361 dollars.
If the pound rises against the dollar, then a single pound will be worth more dollars and the pair’s price will increase. If it drops, the pair’s price will decrease. So if you think that the base currency in a pair is likely to strengthen against the quote currency, you can buy the pair (going long). If you think it will weaken, you can sell the pair (going short).
The spread is the difference between the buy and sell prices quoted for a forex pair.
Like many financial markets, when you open a forex position you’ll be presented with two prices. If you want to open a long position, you trade at the buy price, which is slightly above the market price. If you want to open a short position, you trade at the sell price – slightly below the market price.
What are Pips
When a forex pair increases or decreases in price, that movement is measured in units called pips. A pip is usually equivalent to a one-digit movement in the fourth decimal place of a currency pair. So, if GBP/USD moves from $1.35361 to $1.35471, then it has moved a single pip.
The exception to this rule is when the quote currency is listed in much smaller denominations, with the most notable example being the Japanese yen. Here, a movement in the second decimal place constitutes a single pip.
The decimal places shown after the pip are called fractional pips, or sometimes pipettes.
What is leverage in forex
Leverage allows you to get exposure to large amounts of currency without having to commit too much capital.
A single pip is a very small unit of movement, and while forex pairs tend to be very volatile they often move in relatively minor increments. For this reason, forex traders will either have to trade large batches known as lots, or take advantage of leverage
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