Understanding Forex Trading Systems – Exchange Rates and Spreads Anyone planning to get into forex trading will probably have heard (and believed) that it is a quick and easy way to make money online. He or she will have heard of the trillions of dollars (yes – trillions) that are traded daily on the forex markets, and reasoned that it must be pretty easy to get a hold of just a tiny proportion of all that money (I did!). It isn’t easy and I’m the living proof.
There just isn’t any substitute for climbing that terribly slippery slope we all call The Learning Curve. If you do it right, learn the basics, and absorb as much forex trading information as you can, you’ll save yourself a pile of money. You can of course just lunge right in, as I did, but when your money dwindles, you’ll still have to climb the learning curve. It will be just a little easier – but that will be because your pockets will be empty! So learn the basics of forex trading first – not last! This beginner’s article is about currency pairs and spreads, and is aimed at the complete beginner.
Basically, to make the easy online money we all dream of, we trade a currency like any other product by buying it at one price and then re-selling it again at a different price – just as though dealing wheat or gold. If we have traded well, that second trade will leave us with a nice little profit which is of course the difference between our buying and selling prices. The problem with currencies is that at any instant, there are two prices to cope with depending on whether we are buying or selling. Another complication is that a currency has several different prices, depending on what other currency it is compared with.
We refer to these prices in terms of a currency pair. For example, the EUR/USD refers to the Euro (the European currency) and its rate or value against the US Dollar. The first currency in a pair will always be the base currency, and the second will be the quote currency. So the EUR/USD exchange rate will indicate how many US Dollars a buyer will need if he is to purchase a single Euro, or how many Dollars he will be obtain when he sells one Euro.
In more basic terms, a currency exchange rate is most often specified as a pair of numbers, one of which of the bid price and the other the ask price (for example: 0.8325/29). The ask price is what is used when buying a currency pair, it represents the amount that will be paid in the quote currency to obtain a single unit of the base currency. The bid price is used when selling a currency pair and is what will be received in the quote currency if selling one unit of the base currency.
The bid is always lower than the ask. In currency markets, a simple presentation of the exchange rate is used, as in my example above (eg: 0.8325/29). The first figure (ahead of the slash) is the bid price (what you would receive in dollars when you sell euros). The second figure (after the slash) is the ask (what you will pay in USD if you want to buy euros).
The ask price is commonly reached by removing the final two digits from the first constituent of the number (the bid) and replacing them with the second part (after the slash). For instance, in my example, the ask price is 0.8329. For a second example, 0.8199/02 means a bid price of 0.8199 and (since the ask price is always higher, here we need to adjust the second digit upwards by one too), so the price will then be 0.8203. With a few currency pairs it is usual to quote rates in units of 100 rather than ten, in particular this is the case with USD/JPY (the US dollar against the Yen).
These small units or basis points are called PIPS by traders the world over. So in the examples above, the difference between buy and sell prices (Bid and Ask) are 4 pips and 3 pips respectively. This difference between bid and the ask prices is always referred to as the spread. The spread is effectively the fee that the broker or online spread-betting service is charging to process your trade.
For popular currency pairs like the GBP/USD (UK pound sterling against the dollar), the spread can at times be as low as just three pips. If you buy into a currency with a 3-point spread, and you are betting (say) 10 dollars a pip, then you will instantly show a paper loss of 30 dollars in your account, and the price would have to rise 4 pips (40 dollars) before a profit would be made. The spread is a sort of proportional charge – the more cash you trade per pip, the more you will have to pay in fees.
This fixed spread does have a major benefit however, in that if you trade long periods where a rise of 100-plus pips is conceivable in a single trade, you will still only pay that initial 3-pip spread, which is only a tiny proportion of your profits. Compare this to the poor day-trader who often makes several trades per day and in each trade looks for profits in single percentage figures (say 9 or 10 pips per trade). For him, even a tiny 3-pip spread is an effective 30% tax on his earnings!
Newcomers to forex trading would be well-advised to search for the best, most competitive rate (lowest spread), especially if they are starting out with very small bets (say one or two dollars per pip). If they are going to start small, they are less likely to be penalised if they use a larger online broker or spread-better who will be keen to get their future business. The more traditional brokers (even those with an online presence) will usually charge a wider spread for smaller trades because their own costs are proportionately higher.
All newcomers are also advised to stick to the three or four most popular currency pairs, not only because these will give them the lowest costs (spread) but because liquidity and volatility are usually higher too, making profitable trades that much easier to find and profit from.