Basic Understanding of the Forex Trading
BASED AND COUNTER CURRENCY
A currency pair is made up of two currencies, the base, and the counter currency. The quoting of each currency pair determines which is the base and the counter currency.
The base currency is the first currency you see in the quoted-pair. For example, in the EUR/USD, the Euro is the base currency. The second currency in the pair is referred to as the counter currency.
Simply put, the exchange rate tells you how much of the counter currency is needed to purchase 1-unit of the base currency. For example, if you see a quote for the USD/JPY at 107.96, you would know that you need 107.96 yen to purchase 1 USD dollar.
THE BID/OFFER SPREAD AND LIQUIDITY
Trading activity in the forex market occurs around the clock, providing opportunities to enter and exit trades at any time. Your ability to buy and sell these currency pairs at any time is what makes this market so attractive to many investors.
Most forex brokers do not charge a commission when you enter and exit a trade. Instead, brokers provide you with a price where they are willing to purchase a currency pair and where they will sell a currency pair. This difference is referred to as the bid-offer spread.
· Bid – where a broker is willing to purchase a currency pair.
· Offer – where a broker is willing to sell a currency pair.
You can purchase the EUR/USD at the offer price of 1.1104 or place a lower bid and wait to see if you get filled at your expense. If you buy at the market, you will likely get filled at the offer price. This is called a “market order.” If you place your bid below the offer price, this is referred to as a “limit order.”
You can sell the USD/JPY at the bid price of 107.96. If you sell at the market, you will likely get filled at this level. Alternatively, you can place an offer to sell above this level. This would be considered a limit order.
The spread describes the difference between the bid and offer. When spreads begin to widen, it tells you that the market is becoming less liquid.
SPOT AND FORWARD MARKETS
There are two distinct time horizons used in forex trading, which include spot and forward trades.
The exchange rate of a currency pair for immediate delivery is called the spot price. The settlement of a spot transaction is 2-business days. Any transaction that has settlement beyond 2-business days is referred to as a forward price.
Most of the trading you will be transacting will not require that you take delivery of a currency. Your broker will handle any operational aspects of the currency process for you. You need to know if you trade through a retail forex broker, the exchange that you will trade is spot exchange rates. If you hold your currency pair for more than 2-business days, your broker will need to roll your trade into the forward market.
The forward market has slightly different prices than the spot market as it incorporates the interest charges for holding the currency pair beyond 2-business days.
Futures exchanges also accommodate currency transactions as they allow traders to buy and sell currency futures contracts. These are forward contracts that have a settlement at a set period in the future. The interest charges are already incorporated into the futures prices.
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