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.
by Christopher Temple
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.
To make that easy online money (allegedly), we trade a currency by buying it at one price and re-selling it later at a different price - exactly as though wheeling and dealing in timber or gold. If we have traded wisely, that second transaction will leave us with a profit which is the difference between the buying and selling prices. The complication is that at any instant, there are two prices to contend with depending on whether we are buying or selling. A further complication is that any currency has many different prices, depending on what other currency it is being compared with.
A currency exchange rate is invariably referred to as a currency pair. For example, the EUR/USD refers to the Euro (the European currency) and its rate against the US Dollar. The first currency in a pair is always the base currency, and the second is the quote currency. Thus the EUR/USD exchange rate indicates how many US Dollars a buyer will require to purchase one Euro, or conversely how many Dollars he will be receive 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 price will always be lower than the ask price. In currency markets, a simple abbreviation for the exchange rate pair is used, as in the example above (eg: 0.8325/29). The first figure (before the slash) is the bid price (what you would receive in dollars if you sell euros). The second component (after the slash) is the ask price (what you would 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 (each 1/10 of a basis point) are called PIPS by traders all over the world. So for my the examples above, the difference between buy and sell prices (the Bid and the Ask) are 4 pips and 3 pips. The difference between bid and the ask prices is commonly referred to as the spread. The spread is effectively the charge made by the broker or spread-betting service to process your trade.
For popular and widely-traded currency pairs like the GBP/USD (UK pound sterling against the dollar), the spread can sometimes be as low as three pips. This would mean that - If you bought into a currency with a 3-point spread, and you are betting (say) 10 dollars a pip, then you will immediately show a notional loss of 30 dollars in your account, and the market would then have to rise 4 pips (40 dollars) before a profit would be achieved. The spread is in some respects a proportional charge - the more money you trade per pip, the more you pay in fees.
This fixed spread does however carry a big benefit if your trades last days or weeks and where a rise of 100-plus pips is conceivable in that single trade. Even here you will still only pay an initial 3-pip spread, and that spread will only be a tiny proportion of your profit for the trade. Think of the poor day-trader who will often make several trades in a day, and for each trade he will look for profits in single figures (say 8 to 10 pips or thereabouts). To him, that little 3-pip spread is effectively acts as a 30% tax on his income!
Newcomers are well-advised to shop around to find the best and most competitive rate, 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 will not usually be penalised if they use a large online broker or spread-better who will be keen to get their business. Some traditional brokers (even those with an online presence) will certainly charge a bigger spread for a smaller trade because their own costs will be proportionately higher.
I would also advise Forex newcomers to trade only the four most popular currency pairs (Dollar/Swiss Franc. Pound/Dollar, Euro/Dollar, Dollar/Yen), where they will usually obtain the lowest costs (by spread), and where the liquidity and volatility of these markets will usually make profitable trades easier to find.
Christopher Temple is a successful trader who writes regularly on Forex Currency Trading Systems in his search to help beginners learning Forex Trading Online. Try the links to learn about his book. This article is available as a unique content article with free reprint rights.
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