Forex Basics

Summary: The first thing to notice about currency prices in the Forex market is that there are two of them, called the bid price and the ask price. The second thing to notice is that they don't favor you, the trader; they favor the broker, because that's how he makes his money. The ask price is what you pay should you wish to purchase that currency pair. Using the GBP/USD as an example, let's say you believe the pound is going to strengthen against the U.S. dollar, meaning that the...

The first thing to notice about currency prices in the Forex market is that there are two of them, called the bid price and the ask price. The second thing to notice is that they don't favor you, the trader; they favor the broker, because that's how he makes his money. The ask price is what you pay should you wish to purchase that currency pair. Using the GBP/USD as an example, let's say you believe the pound is going to strengthen against the U.S. dollar, meaning that the chart of the two currencies is going to go up on the graph. In such a trade you would be purchasing the pound now at a lower rate (and by definition, selling the dollar) so that you can sell it later at its (hopefully) higher rate. And, since the pound is the base currency and it controls the direction of the trade, to purchase the pound means to purchase the currency pair. Such a trade is called opening a long position. The bid price is the exact opposite: it's what you pay should you wish to sell, or short, that currency pair. To continue the example of the GBP/USD, let's say you believe the U.S. dollar is going to strengthen against the pound, rather than the other way around. In this trade, you would be purchasing the dollar now (and selling the pound) in order to sell it later. But remember, it's the base currency that controls the direction of the trade. When you purchase the cross currency, by definition you're selling the base; in other words, you're selling the currency pair rather than buying it. So all the signals are reversed: the chart will go down on the graph and the price of the currency pair will decrease. But because you sold or shorted the currency pair rather than purchased it, you want the price to decrease, because it's the price of the base currency that's going down while the price of the cross is going up. In our example, if you shorted the GBP/USD, you would earn a profit if the price of the pair went down. Calculating the number of pips you earn in a short trade is the same as for a long trade. Just ignore which was the purchase or the sale price, and subtract the lower number from the higher one. The difference is the amount of your gain. Note that the ask price is always higher than the bid. You have no choice but to buy high and sell low when trading on the Forex market. The difference between the bid and the ask is called the spread, and that's the amount of money the broker takes as his commission. (Yes, that's all the broker takes; he makes his profit on a large volume of trades rather than large commissions.) Obviously, the smaller the spread, the more money you get to keep out of what you make. Spreads are competitive among brokers; keeping their spreads small is one means of attracting customers. And spreads among the most popular currency pairs are generally smaller than those for pairs that aren't as commonly traded, which is one of the best reasons for sticking with the "majors," as they're called.