Non Forex traders are generally under the impression that the math involved with Forex trading is more complicated than in other forms of trading. Truth is the math involved in currency trading is exactly the same as in any other form of trading. We use the same addition, subtraction, multiplication and division we learned in grade school.
In stock trading the evening news anchor announces the Dow gained 30 “points” today, and in Forex trading we hear the US Dollar is up 30 “pips.” Well that’s fine, but points and pips won’t pay our rent. So let’s convert “points” and “pips” using the basics of Forex math into what it means to us – money. This section will cover basic, but very important principles we utilize in our daily trading activities – prices.
The first thing that you’ll notice about the prices in most currency pairs is they have a couple extra numbers in them compared to a stock quote, or the actual currency exchange rate listed in the travel guide. A typical stock quote looks like “Sprint = 5.71” in the financial section of your local paper; and the published Canadian Dollar to US Dollar exchange rate looks like 1 US Dollar = .98 Canadian Cents. But the traded currency pair rate we use in the Forex market for the same currency is USD/CAD = 0.9887.
Two main reasons exist for breaking down the unit of currency past the .01 cent level. First – the sheer volume of trading on the currency market. The Forex market trades more money in one day than all the stock markets combined trade in a month. Second – the size of the lots we trade in Forex. Stocks typically trade in 100 share standard lots, whereas one standard lot of a currency pair is 100,000 units of the base currency. A full one cent move on a currency pair is a very large movement when considering the huge amount of money being shifted; hence we need to monitor currency prices down to the sub penny level, usually four decimal places out.
Currency pair prices are standardized in the Forex community. As in the above example, the first price in the pair is considered the base price and always has a factor of one. An example would be EUR/USD = 1.5561, where one Euro equals 1.5561 US Dollars. Yet another example GBP/CHF = 2.0510, means one British Pound equals 2.0510 Swiss Francs. The only difference to the look of Forex quotes concerns the Japanese Yen. Since its valuation is in the hundreds, it still retains only two decimal places to the right and typically looks like EUR/JPY = 155.89, again where one Euro equals 155.89 Japanese Yen.
The second thing that is different when viewing trading pair quotes is two sets of numbers for the same currency pair. If you research the trading quote for the EUR/USD, it will look like 1.5669/72. Just as in stock trading you see a bid and an ask price. Some brokers may list this as a bid and offer price. Either way it means the same thing and is easiest to remember as the buy and sell price of the listed currency pair. The first price listed is the amount someone is willing to buy the pair for, the second is the amount someone is willing to sell the pair for. Here someone is willing to buy the pair at 1.5669 and someone is willing to sell the pair at 1.5672. Unless one side or the other changes their price – there is no trade unless those prices are met.
The difference between the buy and sell price is called the spread, and varies between brokers, currency pairs, current volatility and several other factors. The spread is the cost of trading the Forex markets. Most Forex brokers do not charge fees or commissions for executing your trades. Nor do they charge interest for providing the leverage you need to trade the large lot sizes seen in Forex trading. Instead, they make their money with the spread, or the difference between the buy and sell price of the currency pair. With reputable brokers, this is a fair compensation for their services.
In our example above, if you wish to buy the EUR/USD (you think it will go up) you will have to pay the price that someone is willing to sell it at – or the sell price of 1.5672. If you wish to sell the pair (you think it will go down), you will have to sell it at the price someone is willing to pay for it – which is the buy price of 1.5669. Should you execute a buy and then turn around a sell, without any change of price, you will have lost 3 pips of price in the transaction.
What is a Pip? The Official definition of a pip from Investopedia is: “The smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point – for most pairs this is the equivalent of 1/100th of one percent, or one basis point.” For example, the smallest move our EUR/USD currency pair can make is $0.0001, or one basis point. What this means to us in general money terms is: if we traded 1 micro lot in US Dollars and the price went our way 1 pip, we earned .10 cents; if we traded 1 mini lot we earned $1; and if we traded a standard lot and gained 1 pip, we put $10 in our pockets.
There are brokers available who will allow you to trade any size lot you care to trade. But there are three lot sizes that are the most common for the purpose of Forex trading. The standard lot is equal to 100,000 units of the base currency; i.e. if your base currency is US Dollars it is $100,000, if the base is Euro’s, it is ¬ 100,000 and so forth. A mini lot is equal to 10,000 units of the base currency, and micro lots are 1,000 units of the base currency.
This is a very basic explanation of how Forex pricing looks. It can become very sophisticated and complicated if you choose to make it. One reason is a Forex trade actually involves two trades. You are simultaneously buying one currency and selling the other in each trade. But keeping it simple, buying a pair if you think that pair is going to go up, and selling if you think it is going down, and relating pips to money made or lost, allows you the time and brain power to work on the important strategy of executing your trades the right way.