Key Terms to Understand in Forex Trading

Introduction 

Forex trading, a.k.a., foreign exchange or FX trading, is the buying and selling of different currencies to make a profit. In an earlier article, we explained how foreign exchange could be buying stuff online or even exchanging money when you travel to a new country. Forex trading, however, is way more than that. The market is known to fluctuate due to different reasons, and being on top of your game as a trader will help you navigate your way in the global market.

To be ahead, you may want to get acquainted with certain terms regarding forex trading. In its language, forex trading employs terms such as 'pips’, ‘spreads’, and 'leverage’ as its main vocabulary. This piece aims to familiarize you with some of the jargon a novice trader will come across in the forex market as well as empower you to make informed trading choices.

Here are 8 fundamental terms plus 4 others that are less common but still handy if you are starting as a forex trader. Let's get down to them.

Major Terms 

1. Currency Pairs: The Forex market has pairs of all currencies. The base currency refers to the first currency in the currency pair. The first currency in a currency pair is referred to as the base currency. It is the one being evaluated in relation to a second currency's value, which is also referred to as the quote currency. For instance, the USD is the quotation currency and the GBP is the base currency in a currency pair. There are also major pairs, and these currency pairs are traded more often as opposed to the less common currency pairs, which are referred to as exotic pairs.

2. Pip: Also known as a percentage in points, pips represent the lowest increase or decrease in price that is possible for a particular forex trading pair. Normally, currency prices have four places of decimals, so when you hear someone talking about “pip,” this means 0.0001 in most cases. Such an example is when the value of EUR/USD shifts from 1.1050 to 1.1051, indicating a single pip movement.

3. Lot: This refers to how much money is being traded in the forex market. A regular lot is 100, 000 units of the base currency traded at once; however, smaller units exist in mini, micro, and nano sizes, thereby allowing small-scale traders to participate in forex trading too.

4. Spread: Spread is the difference between the selling (bid) and buying (ask) price of a currency. It’s how brokers earn their profit. The size of the spread changes depending on the currency pair and the market’s activity, with smaller spreads usually in more active markets.

5. Leverage: Leverage is simply borrowing money. It allows traders to hold substantially larger positions than they would be able to using just their money. For example, at a leverage of 50:1, you can control $50,000 worth of currency with a mere $1000 of your own money. Although there is an increase in potential profits, the risk is also increased significantly since losses can be huge.

6. Margin: Margin is the money required to maintain a leveraged opening position. It is very similar to a security deposit that guarantees your ability to cover losses, if any. It protects both the broker and the trader. The requirement for a margin usually depends on both the leverage and the size of the trade.

7. Bear/Bull Market: A bull market represents a positive market, i.e., one with rising prices, while a bear market is the opposite of that. Forex trading allows traders to make money in both bullish and bearish markets, but the choice of whether to sell or buy depends on your strategy and the prediction of the markets.

8. Liquidity: Liquidity is how easily you can buy or sell a currency without changing its price much. Major pairs like EUR/USD have high liquidity, meaning trades happen quickly and smoothly. In low-liquidity markets, it’s harder to trade, and buying or selling can cause bigger price changes, making it more difficult to execute trades.

Lesser-Known Terms That Are Also Useful

1. Slippage: Slippage is the difference between the expected price of a trade and the actual price at which it’s executed. This can happen during fast-moving markets or when there aren’t enough buyers or sellers. For instance, if you want to buy a currency at $1.20 but it executes at $1.22, that’s slippage. It can affect your profits or losses based on how prices change.

2. Carry Trade: Carry trade is like borrowing money from a place where interest rates are low (kind of like getting a cheap loan) and then using that money to invest somewhere with higher interest rates. The goal is to make money from the difference between the two rates. But there’s a risk: Since you're dealing with different currencies, if the value of the currency you invested in drops, you could lose more money than you earn from the interest. So, while it can bring good returns, the changing value of currencies makes it risky.

3. Hedging: Think of hedging like buying insurance for your trades. Let’s say you invest in something like euros, but you’re worried the euro might lose value. To protect yourself, you place another trade that will make money if the euro does drop, which helps balance out your risk. In other words, it’s a way to limit potential losses by making sure you have something that gains when your main investment loses.

4. Stop-Loss Order: The stop-loss order is one of the ways to control risks when trading. In common practice, a trade is automatically closed at an already determined price to cut losses. Some also use it to lock in their profit on an open position. A possible use for a trader to issue a stop-loss order could be buying currency at $1.10, and then setting a stop-loss order at $1.05. That means when the trade reaches $1.05, it will be closed at this price to help the trader cut his losses.

Conclusion

Keep in mind that all these terms exist in interaction, not in isolation, to help traders strategize their way through the market effectively. Mastering them is a non-negotiable step for any successful trader in the forex market. Besides all these terms we have discussed, you also need to do more research so that you make better decisions, manage your risks, and therefore, be more confident in your forex trading journey. Our last post on the basics of forex trading will also give you further insight into the topic.