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“Knowledge is the key that turns risk into opportunity.”
Venturing into a financial market as large and as fast paced as the forex market can be daunting. To help you grasp the basics, we have compiled a list of our favourite forex terminology for beginners.
Our glossary will not only help you understand the niche terms in the industry, but also allow you to explore the most crucial points that you need to focus on during your trading journey. Without further ado, let’s delve into our list.
Jump to a Section
- Currency Pair
- Exchange Rate
- Pip
- Bid Price, Ask Price and Spread
- Leverage
- Margin
- Used Margin, Free Margin and Margin Call
- Equity
- Lot Size
- Day Trader
- Candlestick Charts
- Long and Short Positions
- Entry and Exit Points
- Market Order and Limit Order
- Take Profit and Stop Loss
1. Currency Pair
Forex trading involves the buying and selling of currencies which are always traded in pairs. A currency pair represents the quotation of one currency in terms of another, showing you how much of one currency you would need to buy 1 unit of the other.
Let’s give an example for further clarification. Imagine you are planning a vacation to an island where coconuts are the main currency. Before you go, you need to exchange your dollars for coconuts. In this scenario, you have two items involved: dollars (USD) and coconuts (let’s call them ISL, for island currency). The price of the currency pair USDISL essentially tells you how many coconuts you can get for one dollar.
Now, let’s bring this back to forex trading. In the forex market, currency pairs work like this vacation exchange. For example, the currency pair EURUSD shows how many US dollars you can get for one euro. Just as you would monitor the dollar-to-coconut rate to get the best deal for your vacation, traders watch currency pairs to find the best rates for their trades.
2. Exchange Rate
Exchange rate is the price at which one currency can be exchanged for another. In the dollar-to-coconut example above, for instance, an exchange rate of 20 would indicate that 1 dollar can be exchanged for 20 coconuts.
Exchange rates fluctuate continuously based on various factors. These include supply and demand, economic indicators, geopolitical events, and central bank policies. As a trader, you should closely monitor the exchange rate of the pairs you trade in order to manage your risks and better time your trade entries and exits.
3. Pip
A pip, short for percentage in point, is the smallest price movement in a currency pair. For most currency pairs, one pip is equivalent to 0.0001. For pairs involving the Japanese Yen, it is equivalent to 0.01.
Let’s look at an example. For the EURUSD currency pair:
- If the price moves from 1.1200 to 1.1201, there is a movement of 1 pip.
- If the price moves from 1.1200 to 1.1250, there is a movement of 50 pips.
If you were to buy EUR/USD at 1.1200 and its price were to increase to 1.1250, you would gain 50 pips. Conversely, if its price were to decrease to 1.1150, you would lose 50 pips.
4. Bid Price, Ask Price and Spread
Bid Price: The bid price is the highest price at which a broker is willing to buy a currency pair from you (ie. the price at which, you, the trader, sells the currency pair).
Ask Price: The ask price is the lowest price at which a broker is willing to sell a currency pair to you (ie. the price at which you, the trader, buys the currency pair).
Let’s give an example. Assume that for the EURUSD pair, the bid and ask prices are as follows:
Bid Price = 1.1200
Ask Price = 1.1203
This means that 1.1200 US dollars is the price at which you can sell 1 euro while 1.1203 US dollars is the price at which you can buy 1 euro.
Spread: The spread then represents the difference between the bid price and the ask price.
If we take our example for the EURUSD currency pair, we calculate the spread as follows:
Spread = 1.1203 – 1.1200 = 0.0003 (3 pips)
This spread represents the cost of the trade for the trader and it is how brokers earn their profit. A trader would need to overcome the spread to start making a profit. This means the price of the currency pair you trade must move by at least the amount of the spread in your favour.
As a trader, it is beneficial for you to trade with brokers that offer competitive spreads. At XM, for instance, our spreads go as low as 0.6 pips, offering you a lower cost of trading.
5. Leverage
Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from their cash balance alone.
Imagine you want to move a big rock that weighs 1000 pounds. Normally, you wouldn’t be able to lift it by yourself. However, if you have a lever and a fulcrum that can help you, by applying just 10 pounds of force to the lever, you can move the 1000-pound rock. In other words, the leverage is helping you amplify your effort.
In forex trading, leverage works in a similar fashion. Let’s say you want to control a position worth $30,000, but you only have $1,000 to invest. With a leverage ratio of 30:1, your broker allows you to control the full $30,000 position with just $1,000 of your investment.
However, it is important to remember that leverage goes both ways. In the lever example, for instance, we asserted that the leverage helps you amplify your effort. If you were to make a mistake in hitting your target, your mistake would be amplified as well. Just as using a lever requires careful balance to avoid accidents, using trading leverage requires careful risk management because, besides profit, it amplifies losses as well.
6. Margin
Margin is the amount of money required to open and maintain a trading position. For example, if you want to control a position worth $90,000 with a broker offering 30:1 leverage, you need to provide $3,000 as margin ($90,000 / 30 = $3,000).
Margin management is essential to ensure that you have enough funds to cover potential losses. Let’s see how understanding margin can help you assess your account’s health.
7. Used Margin, Free Margin and Margin Call
Used Margin: Used margin is the portion of the funds in your account that is blocked by your broker to maintain your open positions. This ensures that you have enough funds to keep your trades open.
Free Margin: The rest of the funds in your account make up your account’s free margin, indicating the amount that is available to be used to open new positions. Free margin is a good indicator of the capacity to take on additional risk as well as the capacity to absorb the losses from your existing trades.
Margin Call: A margin call is a notification from your broker that additional funds must be deposited into your trading account to cover potential losses on open positions. It occurs when the amount of funds in your account falls below the required margin level. If you fail to meet the margin call by depositing more funds, the broker can forcibly close out some or all of your positions to limit further losses.
As mentioned above, margin management plays a crucial role in assessing your risk exposure. The ratio of used margin to free margin can show how healthy your account is and regularly keeping an eye on your margin levels can help you avoid margin calls.
8. Equity
The equity of a trading account is the total value of the account, including both the balance and the unrealised profits or losses from open positions. It is calculated as:
Equity = Account Balance + Unrealised Profits/Losses
The amount of funds in your trading account is also a useful metric in assessing the overall performance of your account. Equity indicates account health by determining the available margin and reflecting the account’s current value.
9. Lot Size
In forex trading, lot size refers to the standardised quantity of a currency pair being traded. The most common lot sizes are:
- Standard Lot: 100,000 units of the base currency.
- Mini Lot: 10,000 units of the base currency.
- Micro Lot: 1,000 units of the base currency.
Lot size determines the amount you are trading and directly affects the value of each pip movement. You can check out how many lots a contract size is depending on the account type you choose on our Account Types page.
10. Day Trader
This popular term refers to a specific trading style whereby a trader buys and sells financial instruments within the same trading day. A day trader aims to profit from short-term price movements, and typically closes all positions at the end of the day to avoid overnight charges.
It is worth mentioning that day trading, although an extremely popular term, is not the only trading style out there. There are other trading styles that cater for longer or shorter-term strategies. Position traders, for instance, hold positions open for several weeks or even years. Scalpers, on the other hand, open and close positions within a matter of minutes or even seconds.
The trading style that suits you best will depend on your personality, risk tolerance, time availability, and financial goals.
11. Candlestick Charts
A candlestick chart is a powerful tool used by traders to visualise price movements.
Imagine watching a candle burning down. As it burns, it leaves behind a trail of wax that tells a story about how fast it was burning or how much time has passed. A candlestick chart follows a similar logic. Each “candlestick” on the chart represents a specific period of time, like a day or an hour, and it tells a story about how the price of the asset changed during that time period.
The body of the candlestick represents the range between the opening and closing prices, while the wicks (or shadows) indicate the high and low prices. As for the colour of the body, it determines whether the closing price is higher or lower than the opening price.
Candlestick charts are popular among traders because they provide a clear and detailed visual representation of price movements in a format that helps traders easily identify patterns, trends, market sentiment, and potential reversals.
12. Long and Short Positions
Taking a Long Position (Going Long): Going long means buying a currency pair with the expectation that its value will increase.
Taking a Short Position (Going Short): Going short means selling a currency pair with the expectation that its value will decrease.
Traders decide whether to open long or short positions based on their analysis and market expectations. The decision to open a long position is based on positive technical indicators, a strong fundamental analysis, or favourable news affecting the asset. Short positions, on the other hand, are driven by negative technical indicators, a weak fundamental analysis, or adverse conditions affecting the market.
13. Entry and Exit Points
Entry Point: An entry point refers to the price level at which you open your trade.
Exit Point: An exit point is the level at which you close your trade in order to realise profits or cut losses.
Having clear entry and exit strategies before opening your trades is essential for effective risk management. It also takes emotions out of the equation. Traders are less likely to make impulsive trades based on market noise or react emotionally when they have a plan in place.
14. Market Order and Limit Order
Market Order: A market order is an instruction from a trader to buy or sell an asset at the current market price. It is executed immediately at the best available price in the market.
Limit Order: A limit order is an instruction from a trader to buy or sell an asset at a specified price. It is executed only if the market reaches that price.
Different order types offer flexibility in different ways. For instance, market orders allow traders to execute trades quickly at the current market price. Limit orders, on the other hand, allow traders to set specific entry points, enabling them to execute trades at desired price levels. At XM, we support both types of orders to accommodate different trading strategies.
15. Take Profit and Stop Loss
Take Profit: A take-profit order is a type of order used to automatically close a position at a predetermined price level to secure profits.
When a trader sets a take profit order, they specify the price at which they want their position to be closed if the market moves in their favour. Once the market reaches the specified price, the take profit order is triggered, and the position is closed.
Stop Loss: A stop-loss order is used to automatically close a position at a predetermined price level to limit potential losses.
When a trader sets a stop loss order, they specify the price at which they are willing to accept a loss if the market moves against their position. If the market reaches the specified price, the stop loss order is triggered, and the position is closed.
Take profit and stop loss orders are valuable tools for traders as they help manage risk, control emotions and maintain consistency.
Final Thoughts
Knowledge is the key that turns risk into opportunity. You will have noticed that the concepts we have covered are not only about understanding price changes and market analysis but also about having a good grasp of how you can open and close trades or assess your performance on a trading platform.
The use of leverage, the possibility of margin calls, the fact that you can profit from both rising and falling markets — these are all aspects of forex trading that can make or break a strategy. Understanding and mastering these essential terms and how they relate to concepts like market analysis and risk management is crucial for traders aiming to navigate the intricacies of the forex market.
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