Understanding the forex market can feel overwhelming. There are many terms that can throw off new traders. To better understand the forex market and the various parts that are in motion, let’s look at some of the most important terminology you need to know:
The term foreign exchange is simply the process of trading one currency for that of another country. This can be done for a variety of reasons, including:
Foreign Exchange Market
The global economic market in which you can buy and sell, or trade, currencies. It’s also know as the forex market or FX market.
Over-The-Counter (OTC) Trading
The forex market is an over-the-counter (OTC) trading market. This means trades are performed electronically. Anytime you are trading in currencies, you are doing so using OTC trading. This also indicates that currency trading can be done around the world, rather than only in one centralized location. Brokers are available worldwide, 24 hours a day for five days per week.
Within the forex market, there are three submarkets. One of the most important to know is the spot market. This is the largest market and acts as a sort of underlying real asset upon which the foreign and futures market are based. In reality, this is where currencies are bought and sold. The buying and selling occurs using the current price determined by supply and demand.
Arguably one of the most important concepts to understand to work within the forex market is the exchange rate. This is simply a ratio between one currency and another. It shows how one currency is valued against another.
An example of exchange rate would look like this:
USD/CHF, where USD stands for the United States dollar and CHF stands for the Swiss franc.
This exchange rate would show how many Swiss francs are equal to the value of one U.S. dollar.
When you see an exchange rate, the first listed currency is the base currency. This is always considered to hold a value of 1. It’s also known as the reference element.
Returning to our example of USD/CHF, the base currency of that exchange rate would be USD.
Also known as quote currency, counter currency is the second listed currency in an exchange rate. In terms of the exchange rate, you will be seeing how many units of the counter currency are needed to buy one unit of the base currency.
In our example of USD/CHF, the counter currency would be CHF. This would indicate how many units of Swiss francs a person would need to purchase one U.S. dollar.
In the forex market, you will frequently hear about things being long. In terms of foreign exchange, long means “buy.” Frequently, brokers will use phrases like “going long” or “long position.”
When you’re buying a base currency, the hope would be that the base currency will rise in value so that you could sell it back at a higher price. This would be how a trader could make money working within the forex market.
Similar to long, short is simply a way to express selling. If you hear the term long while interacting within the forex market, it means “sell.” Forex brokers will often say “going short” or “short position” as a way of indicating they are selling.
If you are selling a base currency on the forex market, you would hope the base currency would fall in value. This would allow you to buy the base currency back at a lower price.
The basic act of exchanging one currency for another is open position. It indicates that you have a trade in process currently.
Closing a Position
When you are closing a trade, it’s known as closing a position. Similar to cashing out after gambling at a casino, closing a position is simply finishing up a trade, ideally having made profits.
“Flat” or “Square”
If you are “flat” or “square,” there is no open position. Knowing the term “open position” tells us this means that no trade is in progress at the time.
Another term for closing your trade is “squaring up,” which you could also say means closing a position.
Similarly to bidding on something at auction, a bid within the forex market indicates the price that your forex broker would be willing to buy the base currency for. In exchange, they would receive the quote or counter currency in the appropriate value per the exchange rate.
Simply put, the bid is the best available price that a trader could sell to the market.
The opposite of a bid would be the ask. This is the price that a forex broker will sell a base currency for in exchange for the appropriate amount of quote or counter currency. Once again, this is based partly on the exchange rate.
Also known as the offer price, the ask is the best available price a trader can buy base currency for within the forex market.
If you subtract the ask from the bid, you will get the spread. Expressed in terms of “pips,” this provides an easy way to express the difference between what a base currency is valued at and what the quote or counter currency is valued at.
For example, if the euro had a bid price of 1.1051 and was the base currency and the U.S. dollar had an ask price of 1.1053 as the counter or quote currency, it would look something like this:
To find the spread, you would find the difference between the bid price (1.1051) and the ask price (1.1053):
Spread = 1.1051 – 1.1053 = 0.0002 = 2 pips