What is a currency pair?
Currency pairs is the foundation of the FX market. Currencies are traded in pairs, where one currency is the base currency and another one is the counter currency. The quote for a currency pair denotes how many units of the counter currency you must pay to receive one unit of the base currency.
Examples of frequently traded currency pairs:
- EUR/USD
- GBP/USD
- USD/CAD
- USD/JPY
- USD/CHF
- AUD/USD
The first currency in a pair is the base pair, the second currency is the counter currency. So, in the pair USD/JPY the United States Dollar is the base pair, but in the pair GBP/USD the United States Dollar is the counter currency.
What is the Bid/Ask Spread?
The bid/ask spread is the difference between the bid price and the ask price.
Example: You log into a currency trading platform and see that for USD/AUD the bid price is 1.3129 and the ask price is 1.3134. The bid price is what the market maker is willing to pay if you sell. The ask price is what you must pay the market maker if you want to buy. The spread is the difference between the two prices, in this case 0.0005.
The FX market is known for having very tight (small) spreads, especially for heavily traded currency pairs.
What is a pip?
Traditionally, a pip is the smallest displayed price movement of a traded currency. It is short for Percentage In Point. Today, some trading platforms are showing even smaller movements, so called fractional pips.
For most of the major currency pairs, the fourth decimal is the pip.
Example: The currency pair EUR/USD goes from 1.5512 to 1.5519. This is a 7 pip change.
A notable exception is the JPY, where the second decimal is the pip.
Example: You log into a trading platform that shows fractional pips and you watch how the EUR/JPY goes from 142.125 to 142.145. This is a 2 pip change.
Margin trading / leverage
It is common for retail FX trading platforms to extend credit to their clients. This is commonly referred to as leveraged trading or trading on the margin. In essence, you are offered to borrow money to engage in trades. This makes it possible for you to make larger trades than what would be achievable using your own bankroll only.
Example: The AUD you bought earlier has appreciated in price against the USD. You exchange it for USD. You bought 100 AUD for 70 USD and now you are selling 100 AUD for 80 USD. You make a 10 USD profit, before transaction costs. Now, imaging that you would have borrowed money and purchased 10,000 AUD instead. You would have paid 7,000 USD and sold for 8,000 USD. Your profit would have been 1,000 USD before transaction costs.
Borrowing money to trade with is risky since you can end up owing the lender money. If you put 1,000 USD in your trading account and never borrow any money, you can not lose more than 1,000 USD. If you on the other hand put 1,000 USD into your trading account and then borrow 10,000 USD you can end up in a situation where you both lose your 1,000 USD and is forced to repay 10,000 USD to the lender.
Many trading platforms are willing to lend their clients a lot of money. If a trading platform is offering you a 400:1 leverage you are offered to borrow 400 USD for each 1 USD you have in your account. If you have 1,000 USD in your account you can thus borrow 400,000 USD.
When platforms make a profit from each trade carried out by the client (regardless of whether the client profits or not) it makes sense for them to encourage large volume trading.