Understanding Forex Pricing
There are always 2 different prices quoted in the forex market – the bid and the ask.
Bid – price you sell at
Ask – price you buy at
The bid will almost always be the lower of the 2 quotes. Therefore, a trader will always sell at the lower price (bid) and buy at the higher price (ask).
The difference between the 2 prices is called the ‘spread’ (or often called ‘pip spread’). This is your cost of doing business, and is also how the broker makes its money. There are often no commissions in the forex market, making the spread the largest cost per transaction. A “pip” is one ten-thousandth of a point – or the fourth decimal place. Currency exchange rates often change in very small increments – often measured in “pips.” Traders can take advantage of these small changes by using technical analysis tools that predict these changes and by utilizing leverage which allows a trader to control a large contract of currency – eg: a standard lot of $100,000 with a much smaller amount of money in their margin account – often 100 times less than the currency contract.
However, this increased leverage also brings with it significant risk and potential for loss.
Reading Price Quotes
Currencies are designated by a 3 letter standardized code, and the order a currency appears in – either first or second – helps understand the price that is being quoted. The value of the first currency is always 1, and the price being quoted is for the second currency pair listed.
Take a quote on the EUR/USD for example. A price quote of 1.4321 means €1.00 EUR (EUR being the first currency listed in the pair) can be purchased for $1.43 USD.
If an investor were to buy a mini contract at this price (a mini contract is commonly known as a 10,000 currency contract), the investor would purchase €10,000 EUR in exchange for $14,321 USD. For the sake of example, assume the price appreciated to 1.4350; the same €10,000 EUR owned by the investor is now worth more US Dollars – $14,350 USD – thus making a profit of $29 on the transaction – less the pip spread which we’ll cover shortly.
Price Interest Point
Forex prices and profits are often referred to in ‘PIPs’, which is the last digit seen in a price: 1.4321. From the previous example, the trader saw a profit of 29 pips (also simply known as ‘points’):
1.4350 – 1.4321 = 0.0029
What Influences Price?
Forex markets and prices are mainly influenced by international trade and investment flows. It is also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions, especially interest rates, inflation, and political stability, or as if often the case, political instability. Though economic factors do have long term effects, it is often the immediate reaction that causes daily price volatility, which makes Forex trading very attractive to intra-day traders.
Currency trading can offer investors another layer of diversification. Trading currencies can be viewed as a means to protect against adverse movements in the equity and bond markets, movements that of course also impact mutual funds. You should bear in mind that trading in the off-exchange foreign currency market is one of the riskiest forms of trading and you should only invest a small portion of your risk capital in this market.
