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Forex - pips, spread, margin, leverage

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    Forex - pips, spread, margin, leverage

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    Currencies are traded in pairs and exchanged against each other. The majority of currencies are traded against US Dollar. The first currency in the exchange pair is called Base Currency and the second currency is called the Counter Currency or Quote Currency.

    The exchange rate tells you how much of the counter currency must be paid to buy one unit of the base currency. The exchange rate also tells the seller how much is received in the counter currency when selling one base unit. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of Euros that 1.2083 USD must be paid for one Euro.

    Spread is the difference between the buy and sell price. Like in stock market ask and bid. This is the difference between the market makers selling price and the price the market maker is ready to pay to buy the same currency. This means that if you buy a currency and then sell the currency before the price has changed you will lose money because of the spread. Bid price is always lower than the ask price, thus the situation. For example if EUR/USD bid/ask is 1.2010/1.2015 then by selling the security before the price has changed, you will lose 5 pips.

    Now you might be wondering what the heck the pip is. I know that when I first started reading about forex and such I wondered for quite a bit what is that pip they are talking about. Basically, as currency rates do not change a lot then the changes are brought out in pips. One pip is 0.0001 in case of all the currencies excluding Yen. For Japanese Yen one pip is 0.01. So if the exchange rate changes by 20 pips then now you’ll know it means 0.0020.

    When in banks the exchange rates – buy/sell rates (spread) for different currencies may vary even more than 1000 pips, in forex market it’s a lot smaller and because of that investors may profit even from only small price movements.

    Price of a currency is called Quote and there are two kinds of quotes – direct quotes and indirect quotes. Direct quote is the price for 1 US dollar in terms of the other currency. Indirect quote is the price of 1 unit of a currency in terms of US Dollars. The market maker provides the investor with quotes. The quote is the price the market maker will honor when the deal is executed.

    When quote is not put against US dollar but against another currency, this is called Cross rates. For example GBP/YEN. This is called cross rate because it is calculated via US Dollar. To give you an idea how cross rate is calculated:

    GBP/USD = 1.7464

    USD/JPY = 112.29

    Thus GBP/JPY = 112.29*1.7464 = 196.10

    Don’t worry about the calculation though, in different forex trading platforms the calculations are all done for you. But it’s still good to know where the rate has come from.

    Now, lets talk about MARGIN. Trading providers need collateral to make sure that the investor can pay up in case of losses. This collateral is called margin and is also known as minimum security in forex. This is basically the deposit to the trader account that is intended to cover and possible trading losses in the future. Margin enables traders to hold a lot larger position than their account value.

    Some trading providers also require a maintenance margin that is used to cover administrative costs and such. And most importantly to cover loss in case of a “gap” or “slippage” in rates. For example if you have set a stop-loss rate to 1.8075 but the the rate jumps from 1.8050 directly to 1.8090. To cover loss that might come from here, the maintenance margin is used.

    Leverage allows traders of forex market use credit. You might sort of compare it with short selling in stock market. Not the same, but starting traders might find the idea bit similar.

    The leverage may allow a trader control 50-400 times bigger amount than he has actually deposited. For example if you deposit just $100 you may be able to actually play with $10 000. Of course, in this case this $100 is the margin you are willing to lose, everything’s at stake.  

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