Introducing the financial markets
What is a 'pip'?
Unlike share price movements, which are measured in recognisable units of currency such as pence or cents, forex changes are measured in very small units called pips.
For example, if the EUR/USD price moves from 1.20160 to 1.20170, that 0.0001 USD rise in value represents one pip.
For most major currency pairs, a pip represents a one-digit move in the fourth decimal place.
One important exception to this is where the yen is the counter currency. Here the second decimal place is the one to watch.
Any extra decimal places shown in the price are known as fractional pips or pipettes.
IncorrectA pip is a move in the fourth decimal place for this pair. So 61 – 52 = 9 pips.
What is a 'lot'?
Each one-pip movement in a forex price is only worth a tiny amount. So, to take advantage of these small changes in value, forex is traditionally traded in large batches called lots.
A standard lot is 100,000 units of currency. You may also come across mini lots and micro lots, which represent 10,000 and 1000 units respectively.
|Units of currency
Small investors generally don't have access to such large amounts of money, so many forex brokers allow clients to trade on leverage.
Leverage essentially means you can open a large market position with a relatively small deposit - called margin. Any profit or loss is based on the full position however, so gains or losses could far exceed this amount. We look at leverage in more detail in the 'Orders, execution and leverage' course.
Theoretically you can exchange any currency in the world for any other currency, which means the variety of forex pairs you could potentially trade is vast. You could even speculate on the price of the Armenian dram versus the Zambian kwacha (AMD/ZMW) if you found a broker willing to trade that pair.
In practice, however, the majority of forex trades take place on a few select currency pairs called the majors. What constitutes a major pair varies widely depending on who you speak to, but most include the following six which account for over 80% of global forex trade:
|Euro / US dollar
|US dollar / Japanese yen
|Sterling / US dollar
|US dollar / Swiss franc
|US dollar / Canadian dollar
|Australian dollar / US dollar
Notice that all these pairs include the US dollar, which is by far the single most traded currency in the world.
Minor and exotic pairs
Pairs which are traded less frequently are known as minor currency pairs. You may also see them called cross-currency pairs or simply crosses, particularly if the US dollar isn't involved. The most popular minor pairs tend to contain the euro (EUR), sterling (GBP) or the Japanese yen (JPY).
Some forex brokers may also refer to exotic or emerging pairs. These generally consist of one major currency against another from a small or emerging economy, for example GBP/MXN (sterling vs Mexican peso) or USD/PLN (US dollar vs Polish zloty).
Finally, you may come across forex classes which are based on a region, such as Australasian pairs or Scandinavian pairs. These classes set currencies from their respective regions against one another, or pair them with others from around the world. For example AUD/NZD (Australian dollar vs New Zealand dollar) could be categorised as an Australasian pair, while EUR/NOK (euro vs Norwegian krona) would be a Scandinavian pair.
IncorrectNOK/SEK = Norwegian krona vs Swedish krona → Scandinavian pair.
IncorrectUSD/JPY = US dollar vs Japanese yen → Major pair.
IncorrectGBP/HUF = UK pound vs Hungarian forint → Exotic pair.
IncorrectAUD/NZD = Australian dollar vs New Zealand dollar → Australasian pair.
IncorrectEUR/CAD = Euro vs Canadian dollar → Minor pair.
What drives the forex markets?
We've looked at what forex is and how to place a trade, but why do currency prices change?
Well, currencies are effectively barometers for the health of the region they represent. So, if you place a trade hoping a particular currency will rise, you are essentially betting on the economy of that country/region.
In general terms, the stronger the economy of a country/region, the stronger its currency will be compared to other currencies.
Therefore, the factors that affect a country/region's economy tend to have the greatest influence on a currency's price. These include:
- Interest rates
- Inflation rates
- Government policy
- Demand for imports and exports
- Economic statistics such as a county's growth figures, unemployment levels and manufacturing data
- Forex movements are measured in pips. For most pairs, a pip is a one-digit move in the fourth decimal place of the price
- Forex is traded in standard lots, which represent 100,000 units of currency
- Currency pairs are usually classed as major, minor or exotic
- Generally, the stronger the economy of a country/region, the stronger its currency will be