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Australian Financial Services (AFS) Licence 246566

Components of a Forex Deal

What are currency pairs?

In the foreign exchange market, currency is traded in pairs. Pairs have meaning in relation to each other so must always stay together.

The two currencies in a currency pair are traded one against the other. The rate at which they are traded is called the exchange rate. The exchange rate is affected by currency supply and demand.

Most common currencies

The most common currencies traded in the market are called “majors”. Most currencies are traded against the United States dollar (USD). USD is traded more than any other currency. The five currencies most traded next are: the euro (EUR); the Japanese yen (JPY); the British pound sterling (GBP); the Swiss franc (CHF), and the Australian dollar (AUD). Trades of the six major currencies total 90% of the market.

The most common currency pair is EUR/USD.

Pairs exchange rate

The exchange rate is always changing. The value of one currency is determined by market supply and demand forces, by comparing it to another currency. In a currency pair, the first currency is called the “base currency”; the second currency is called the “quote currency” or “counter currency”.

When you buy a currency pair, you buy the base currency and sell the quote currency. The exchange rate tells buyers how much of the quote currency they need to buy one of the base currency. The order in a pair always stays the same, being a common approach by the industry. USD/JPY, for example, is a pair (USD = base, JPY = the quote). The order within the pair, in the way you use the term, does not change. So you either BUY it or SELL it, depending on the direction of the trade. For example: USD/JPY – you either BUY JPY using USD or you Sell JPY to get USD. On the currency rate table on the easy-forex® website you can view the way in which each pair available for trade is ordered.

Here is an example: EUR/USD 1.2500 means you need 1.25USD to buy one euro. It also means if you sell one euro you get 1.25USD. All trades involve buying one currency and selling another currency at the same time. If in the next day the Euro is rising against the USD and the exchange rate is now 1.26, for every 1 Euro that you bought, you have earned 1USD cent. Or, if you traded the opposite direction, for every EUR that you sold (at 1.25) you lost 1USD cent (since you “buy” back the EUR for 1.26).

What is the Spread?

Prices of forex pairs are quoted in pairs; the bid price and the ask price. These two prices are not the same, as the ask price, which is the price quoted on the right is usually higher than the bid price, quoted on the left. The difference in the two prices is known as the spread, and this is the broker’s commission. The spread is measured in pips.

In order to collect the spread, the broker will sell the currency to the trader at the ask price and buy the currency back from the trader at the bid price. The sequence will depend on what trade the trader is performing (buy or sell; long or short).

So if for the EURUSD, the price quotation is 1.1347/1.1349, the bid price here is 1.1347 and the ask price is 1.1349. The difference between the two prices is 0.0002 or 2 pips.

Calculating the Value of the Spread

The value of the spread will determine how much the trader pays to the broker in monetary terms whenever a trade is opened. The value of the spread is calculated as a function of the number of pips that make up the spread and the size of the position.

a) Number of pips that make up the spread.

There are currencies with spreads as low as 1.8 or 2 pips such as the EURUSD, and there are some with spreads as wide as 50 pips such as the pairing of the US Dollar with the Swedish Krona (USDSEK). When a trader picks a currency pair to trade, the spread for that currency pair must be considered carefully. This is because if a trader’s account size is too small to handle heavy spreads, this may end badly for the trader if the trade ends up as a loss.

b) Size of the position

A standard lot is equivalent to $100,000 of base currency. This is what it takes to set up a position with one full lot in the market. There are individual differences as to the size of a standard lot with respect to currency pairs such as the Yen crosses. For our illustration, the standard lot is $100,000 base currency. All other trade sizes draw inference from this position. So a mini-lot which is one-tenth of a standard lot, is worth $10,000 of base currency. Five standard lots is worth $500,000 of base currency.

In calculating the value of the spread, the number of pips (in decimal points) is multiplied by the size of the position. So if a trader wants to purchase a mini-lot size of EURUSD, and the EURUSD is quoted as 1.2434/1.2436, then the value of the spread is:

10,000 X 0.0002 = $2

So the trader pays a spread of $2 for opening a mini-lot position on the EURUSD, no matter whether the trader is going short or long on this pair.

What is a pip?

A pip is a number value. In the Forex market, the value of currency is given in pips. One pip equals 0.0001, two pips equals 0.0002, three pips equals 0.0003 and so on.

One pip is the smallest price change that an exchange rate can make. Most currencies are priced to four numbers after the point. For example, a five pip spread for EUR/USD is 1.2530/1.2535.

In the major currencies, the price of the Japanese yen does not have four numbers after the point. In USD/JPY, the price is only given to two decimal points – so a quote for USD/JPY looks like this: 114.05/114.08. This quote has a three pip spread between the buy and sell price.

Quotes

The price of a currency is called the “quote”. There are two forms of quotes in the Forex market: direct quotes, and indirect quotes.

A direct quote is the price for one US dollar in terms of another currency.

An indirect quote is the price for one UNIT of another currency in terms of the US dollar.

Please note: in general, most currencies are quoted against the USD (e.g. – “direct quote”).

But, the EUR, GBP, AUD, NZD (as well as Gold XAU and silver XAG) are indirect quoted, for example: GBP/USD.

The quote is the price to a currency pair that the deal will be made with. This is unlike an “indication”, where the price given by a market maker is only informational (for trader’s knowledge, rather than for execution). Real time quotes are provided to easyMarkets logged in users.

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