Many beginners are intimidated by forex trading because it can appear quite complex. Some of the more common difficulties new traders experience are understanding currency quotes, how to short an FX pair as well as some of the jargon used by experienced traders.

In this lesson, we’ll walk you through some important elements to be aware of before you start trading.

Key forex trading terms

Before we get into the ins and outs of trading forex, it might be helpful to learn some of the terms we’ll use in this course and discover what they each mean.

• Base currency: the first currency that appears in a pair. Looking at EUR/USD, the euro is the base currency. One unit of the base currency is the ‘anchor’ of the quoted amount, meaning that the figure you see is how much of the secondary currency (USD) you’d need to buy that one unit (eg $1 could buy €0.99, provided that’s the quoted amount at the time a trade is opened).
• Variable/quote currency: the second currency in the pair. If we looked at the same EUR/USD pair as an example, the US dollar would be the variable (or quote) currency. As mentioned, it represents the amount of currency units you’d need to buy one unit of the base currency.
  

The screenshot below shows the currency pair AUD/USD.

Bid price: the highest price that a buyer (bidder) is prepared to pay for one unit of currency. This is the price you’ll see when you’re looking to open a ‘sell’ or ‘short’ trade on a forex pair, usually to the left of a deal ticket and is often in red. This is also the price you’ll pay per unit of the base currency to close out a short position.

Ask price: this is the opposite of the bid and represents the lowest price a seller is willing to accept. When you’re looking to open a ‘buy’ or ‘long’ trade on a currency pair, this is the price you’ll see and is usually to the right of a deal ticket and in blue. Opposite to the bid price, this is how much you’ll pay per unit of the base currency to close out a long position.

Spread: the difference between the bid and the ask price. It represents the actual spread in the underlying forex market plus the additional spread added by your broker. Some brokers may charge a commission on top of this spread while others primarily charge the spread as the main cost of trades. Note that other fees and charges may apply, like overnight funding.

Pips: also known as a point, a pip refers to the final, right-most whole value in a forex pair’s price (often the fourth decimal place). This is often how traders refer to movements in a currency pair, eg GBP/USD rallied 100 pips/points today.

Lots: forex is normally traded in lots, which is simply the size of your trade – ie the number of currency units you want to buy or sell. A standard lot size is equivalent to 100,000 units of the base currency (eg €100,000 in one lot of EUR/USD). You can also purchase a mini-lot, which is 10,000 units, as well as a micro-lot worth 1000 units. However, many brokers are flexible and allow trades in non-standard lot sizes.

Leverage: leverage enables traders to open positions while only putting up a fraction of the full value of the trade. The main advantage of trading with leverage is that it amplifies gains as all profits are generated on the full value of the position. However, in the opposite sense, all losses you make on your trade are just as amplified.

Margin: the amount of money needed to open a leveraged position, almost like a ‘deposit’. It’s the difference between the full value of your position and the funds being lent to you by the broker.

Margin requirement: the amount of available capital needed to keep your positions open; that is, the funds in your account that aren’t tied to any trades. The more trades you have open on your account, the more you may need to fund it from time to time to avoid being put into margin call by your broker, which can ultimately lead to your position being closed out due to insufficient funds.

Margin call: this happens when the total capital on your account, plus/minus any profits or losses, dips below a specified level (margin requirement).

Liquidity: a currency pair is considered ‘liquid’ if it can easily be bought and sold due to there being many participants trading it. This can be measured by the number of pips between the bid and offer prices – smaller values relate to more liquid markets. Liquid markets are usually preferred to illiquid ones as they’re less likely to experience huge changes in their buy and sell prices under normal market conditions. But because they’re usually major pairs, they can still experience high levels of volatility during big events like elections and interest rate decision announcements.

Volatility: this normally works hand in hand with liquidity. It describes the degree of price movements on a particular market. As mentioned, major pairs normally have low volatility as there are likely multiple people opening and closing trades on it, but this largely depends on market sentiment. Illiquid pairs – usually emerging markets like EUR/CNH – can experience high levels of volatility because their price can be impacted by large trades in either direction (long or short).

Market sentiment: this is the prevailing attitude traders have towards a particular market. It can be bullish, meaning there’s optimism about a currency pair’s future (that it will grow), or it can be described as bearish, meaning the general view is that it will depreciate in value.

Reading a forex quote

All traders need to understand how to read a forex quote. This is what determines the price you’ll pay to enter and exit a trade.

Remember, the first currency in the EUR/USD pair is the base currency, which is the euro, while the second currency (USD) is known as the variable or quote currency.

Prices are offered up to five decimals for many FX markets, but the first four are the most important for most pairs.

An important exception to note is in Japanese yen pairings where the yen is the quote currency. In this case, the second decimal place represents one pip, for example:

In other currency pairs, the number to the left of the decimal point indicates one unit of the counter currency. The following two digits are the cents.

This means the value of the currency from the screenshot above is 97 cents ($0.97). The third and fourth digits represent fractions of a cent and are referred to as pips.

Should the euro depreciate against the US dollar by 100 pips, the new sell price will reflect a lower price, which means it’ll cost less in USD to buy 1 euro. This is how you’d calculate this:

Pips explained

The word pip to a new forex trader sounds straightforward enough – a pip means a small fruit seed, so of course the small movements in forex prices would be so named, right? Not quite.

Pip actually stands for ‘percentage in point,’ and as you’ve come to learn, this is the base unit of measurement in a currency pair. The value of a pip will differ based on the counter-currency in the pairing.

For currency pairs in which USD is the counter-currency, or listed second in the quote, the pip value or cost will often be $1 for a 10,000 lot of currency, which would also mean a pip value or cost of $0.10 for a micro-lot (1000 units) and $10.00 for a standard lot (100,000 units).

So, if an investor buys a micro-lot (1000 units) of EUR/USD, each pip gained or lost would be worth ten cents. If the same investor buys a mini-lot (10,000 units) of EUR/USD, each pip gained or lost would be worth $1 each. And finally, if they buy a standard lot, the pip value would be $10 per point.

The cost or value of a pip is an extremely important data point for forex traders to be aware of as this is how spreads are communicated.

Gaining experience without risking hard capital

One of the biggest risks or drawbacks of learning how to trade a market is the fact that trading can be a costly endeavor, and the risk of financial loss is ever-present when trading actual hard capital on a trading platform.

Whenever one buys or sells a forex pair, they bear the risk of losing money. This can be an expensive tuition for a new trader that’s still learning their ways.

But many brokers offer demo accounts so that new traders or prospective customers can familiarize themselves with the market, the platform they’ll use, and the dynamics of forex trading before ever making a deposit.

A demo account can offer a simulated trading environment where you can develop and implement your strategies and learn to manage your trades. Your IG Academy account gives you access to a free IG demo account with CHF 20,000 in virtual funds to practice with.

You may want to use it to practice the learnings from this course as it’ll give you a simulated experience of trading the markets with real money.

Reasons why people trade forex

Aside from the clear reason of exchanging money in a foreign country, people trade forex with the goal of gaining profits, though the risk of losing money is ever-present.

They do this by buying a currency ‘low’ and then selling ‘high,’ or vice versa with short positions in which the goal would be to ‘sell high’ and ‘cover lower.’

And not forgetting, of course, that some people and global institutions trade forex to hedge their currency risk.

In addition to the reasons outlined above, people also trade forex for these benefits:

1. Low transaction costs: forex brokers typically make their money on the spread, provided the trade is opened and closed before any overnight funding charges are applied. This can make it more cost effective when weighed up against other markets, like equities, which normally incur a commission charge. However, some forex brokers charge a commission so you may want to confirm all the trading costs applicable to your trade before opening it
2. Low spreads: bid/ask spreads for major FX pairs can be quite low due to their liquidity. When trading, you’ll need to bear in mind that you’ll need to pay the spread to both open and close trades, even when the market moves in your favor
3. Leverage trading: trading forex involves the use of leverage. As you’ve learned from the previous lesson, this means that you needn’t pay the full cost of the trade but instead only put down a fraction of its cost but still gain full exposure to the market. Remember, this has the potential to magnify your profits but also your losses