Major and Minor Currencies

The eight most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, NZD, and AUD) are called the major currencies or the “majors.” These are the most liquid and the most sexy.

All other currencies are referred to as minor currencies.

Base Currency

The base currency is the first currency in any currency pair. The currency quote shows how much the base currency is worth as measured against the second currency.

For example, if the USD/CHF rate equals 1.6350, then one USD is worth CHF 1.6350.

In the forex market, the U.S. dollar is normally considered the “base” currency for quotes, meaning that quotes are expressed as a unit of 1 USD per the other currency quoted in the pair.

The primary exceptions to this rule are the British pound, the euro, and the Australian and New Zealand dollar.

Quote Currency

The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency.

Pip

A pip is the smallest unit of price for any currency.

Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit, that is, EUR/USD equals 1.2538.

In this instance, a single pip equals the smallest change in the fourth decimal place – that is, 0.0001.

Therefore, if the quote currency in any pair is USD, then one pip always equals 1/100 of a cent.

Notable exceptions are pairs that include the Japanese yen where a pip equals 0.01.

Pipette

One-tenth of a pip. Some brokers quote fractional pips, or pipettes, for added precision in quoting rates.

For example, if EUR/USD moved from 1.32156 to 1.32158, it moved 2 pipettes.

Bid Price

The bid is the price at which the market is prepared to buy a specific currency pair in the forex market.

At this price, the trader can sell the base currency. It is shown on the left side of the quotation.

For example, in the quote GBP/USD 1.8812/15, the bid price is 1.8812. This means you sell one British pound for 1.8812 U.S. dollars.

Ask/Offer Price

The ask/offer is the price at which the market is prepared to sell a specific currency pair in the forex market.

At this price, you can buy the base currency. It is shown on the right side of the quotation.

For example, in the quote EUR/USD 1.2812/15, the ask price is 1.2815. This means you can buy one euro for 1.2815 U.S. dollars.

The ask price is also known as the offer price.

Bid-Ask Spread

The spread is the difference between the bid and ask price.

The “big figure quote” is the dealer expression referring to the first few digits of an exchange rate.

These digits are often omitted in dealer quotes.

For example, the USD/JPY rate might be 118.30/118.34, but would be quoted verbally without the first three digits as “30/34.”

In this example, USD/JPY has a 4-pip spread.

Quote Convention

Exchange rates in the forex market are expressed using the following format:

Base currency / Quote currency = Bid / Ask

Transaction Cost

The critical characteristic of the bid/ask spread is that it is also the transaction cost for a round-turn trade.

Round-turn means a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair.

For example, in the case of the EUR/USD rate of 1.2812/15, the transaction cost is three pips.

The formula for calculating the transaction cost is:

Transaction cost (spread) = Ask Price – Bid Price

Cross Currency

A cross-currency is any currency pair in which neither currency is the U.S. dollar.

These pairs exhibit erratic price behavior since the trader has, in effect, initiated two USD trades.

For example, initiating a long (buy) EUR/GBP is equivalent to buying a EUR/USD currency pair and selling GBP/USD.

Cross-currency pairs frequently carry a higher transaction cost.

Margin

When you open a new margin account with a forex broker, you must deposit a minimum amount with that broker.

This minimum varies from broker to broker and can be as low as $100 to as high as $100,000.

Each time you execute a new trade, a certain percentage of the account balance in the margin account will be set aside as the initial margin requirement for the new trade.

The amount is based upon the underlying currency pair, its current price, and the number of units (or lots) traded. The lot size always refers to the base currency.

For example, let’s say you open a mini account that provides a 200:1 leverage or 0.5% margin. Mini accounts trade mini lots. Let’s say one mini lot equals $10,000.

If you were to open one mini-lot, instead of having to provide the full $10,000, you would only need $50 ($10,000 x 0.5% = $50).

Leverage

Leverage is the ratio of the amount capital used in a transaction to the required security deposit ( the “margin“).

It is the ability to control large dollar amounts of a financial instrument with a relatively small amount of capital.

Leverage varies dramatically with different brokers, ranging from 2:1 to 500:1.