Forex Market FAQ

What is a PIP?

In the FX market, currencies are always priced in pairs. The quoted price is the level at which the market maker is willing to buy/sell the currency pair. In the wholesale market, currencies are quoted out to four decimal places, with the last placeholder called a point or a pip. A pip in most currencies is one divided by 10,000 of an exchange rate (in USD/JPY, it is one divided by 100).

How do I know which currency I am buying and which I am selling?

FX currency trades result in the simultaneous buying of one currency and the selling of another. The objective of currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought has increased its value relative to the one you sold.

The first currency in the pair is referred to as the base currency, while the second currency is known as the counter or quote currency. The base currency is always the basis for the buying or selling of the position.

Consider the following example.

The current bid/ask price for USD/JPY is 122.02/122.07, meaning you can SELL $1 US for 122.02 Yen or BUY $1 US for 122.07 yen.

Suppose you decide that the US Dollar (USD) is undervalued against the Japanese Yen (JPY). Since the US dollar is the base currency, to execute this strategy you would BUY the pair i.e., buy dollars (simultaneously selling yen), and then wait for the exchange rate to rise. If you believe that the Japanese yen will appreciate against the US dollar, you would SELL the pair.

How can I enter a short (sell) order to sell a currency pair that I don't own?

In every currency trade, you are borrowing one currency to buy another. For example, if you buy the USD/JPY, you are simply borrowing yen to buy US dollars. If US dollars rise in value, you will be able to sell them for more yen than you borrowed and make a profit. If you enter a short, or sell, order on the USD/JPY, you are simply borrowing US dollars to buy Japanese yen. If the yen rises in value, then you will be able to sell them back for more dollars than you initially borrowed and make a profit. In every trade, regardless of whether you are buying or selling the currency pair, you are buying and borrowing a currency.

What is the difference between a market maker and broker?

In the equities, futures, and currency markets, the vast majority of orders are executed by what is known as a market maker – a central party whose primary role is to buy from sellers and sell to buyers, thus ensuring that the market can operate smoothly. Market makers operate by charging a spread – a small difference between the price at which they buy and sell.

For example, the market maker will buy from a seller at a price of 45 and sell to a buyer at a price of 50 – thus reaping a profit of 5. All market makers charge a spread, as it is their primary source of compensation for the service they provide.

Brokers, on the other hand, charge a commission – a per trade transaction cost they apply for their services. Trading directly with a market maker – and thus bypassing the commission costs imposed by brokers – is fairly difficult in the equities and futures market, and is generally associated with expensive software fees or clearing fees. In the currency market, though, no such hindrances exist. Clients can bypass brokers altogether, and can trade directly with the market maker while incurring the spread as their only transaction cost.

How do brokers make money if they do not charge commissions?

They are compensated for services through the bid/ask spread.

What is a spread?

As with all financial products, FX quotes include a bid and ask price. The “bid” is the price at which a dealer is willing to buy (and clients can sell) the base currency in exchange for the counter currency. The “ask” is the price at which a dealer will sell (and clients can buy) the base currency in exchange for the counter currency. The difference between the bid and the ask price is referred to as the spread.

The spread defines the trader’s cost, which can be recovered with a favorable currency move in the market. The pair of currencies being traded, the rate at which the currency pair is trading, and the size of the position being traded all may determine the value of a pip.

Why is leverage important in the FX market?

Leverage is a means of enhancing returns or value without increasing the investment size. Leverage allows you to magnify your potential returns by trading more than you actually deposit.

For instance, with most FX brokers, traders can utilize up to 100:1 leverage -- meaning they can trade 100 times the amount they deposit -- without being liable for more then their deposit. Therefore, with a $100 margin deposit you can take a 10,000 base currency position in the market. In the event the total value of the account falls below margin requirements, your broker would probably automatically close all open positions. This prevents clients' accounts from falling below the actual available equity.

Bear in mind, though, that leverage is a double-edged sword. Without proper risk management, this high degree of leverage can lead to large losses as well as gains.

How does margin work in the FX market?

While trades are made in increments of at least 10,000 units of currency, traders do not need to have such a large amount in their account. Instead, they can trade using margin, which allows them to essentially borrow the rest.

For each lot (term used for increment of 10,000 units of currency), clients must maintain $100 in the account for each lot of currency being traded (approximately 100:1 leverage). Once the account value falls below $100 per lot, all positions are closed. This ensures that traders can use margin without being liable for more than they deposit.