To make a profit in forex trading, you must buy low and sell high, although not necessarily in that order. To know how much you are paying or what you are receiving from a currency transaction requires that you know how currencies are quoted.
Virtually every country, with some small exceptions, has its own currency, and most of them can be traded. However, the currencies of a few countries are the most actively traded, and constitute, by far, the largest volume of trades. The big 5 are the United States dollar (USD), Euro (EUR), Japanese yen (JPY), the British pound (GBP), and the Swiss franc (CHF).
Each currency is symbolized by a 3-letter ISO (International Organization for Standardization) code: the 1st 2 letters designate the country and the 3rd designates the currency. The most famous illustration of this is for the United States dollar—USD. Other countries that call their currency dollars include the Canadian dollar (CAD), the Australian dollar (AUD), and the New Zealand dollar (NZD). As you can see, each of this symbols ends in "D", which designates the dollar name.
However, sometimes the country name or currency that is symbolized is not the most common name. Thus, the symbol for the Swiss franc is CHF, where CH stands for Confederation Helvetica, which refers to Switzerland, and MXN stands for the Mexican Nuevo Peso, even though the most common name for Mexico’s currency is simply the peso.
One of the purposes of money is as a convenient form of barter. Money is desired not so much for the thing itself, but what it can be exchanged for. Thus, in virtually every transaction, money constitutes one side of the transaction. Thus, money is exchanged for a car, for groceries, for services, and so on. Because money is the universal barter, everything else is measured in terms of it. For instance, I can buy a loaf of bread for $2 and a car for $20,000. Both prices are expressed as the amount of money that would have to be given in exchange for the item.
However, there is an equivalent way of thinking about these transactions that allows a better understanding of currency exchanges. Buying a loaf of bread for 2 dollars is the same as selling 2 dollars for a loaf of bread. In other words, it is nothing more than an exchange. Since money is the medium of exchange, everything is priced in terms of money.
But when you buy currency, then both items exchanged are money. When you are looking at currency quotes, it is important to understand the format of the quote.
Currency is always quoted in pairs. The 1st quote is for the base currency, and is a unit of that currency. The 2nd currency is the quote currency (aka counter currency), which is the amount of the currency equal to a unit of the base currency.
Base Currency/Quote Currency = Exchange Rate
Example: If GBP/USD = 2, then it takes 2 U.S. dollars to buy 1 British pound.
Quote Currency/Base Currency = 1/(Base Currency/Quote Currency)
Example: If GBP/USD = 2, then USD/GBP = 1/2 = 0.5; thus, 1 USD can be exchanged for ½ GBP.
Thus, a quote for GBP/USD is the number of United States dollars (USD) needed to buy 1 Great Britain pound (GBP), or how much USD would be received for 1 GBP.
Tip: Find the approximate foreign exchange rate quickly by typing the currency pair in the search box for Google (example: EUR/USD) or Bing (example: EUR/USD). The 2 search engines do not always provide the same quote, so just use it as a quick approximation.
When you buy something in a store in the United States, the smallest unit of price is 1 cent. This is because the coin with the least value is the penny, and so it would not be possible to sell or buy something for less than that, if only a single item is purchased, as is usually the case. Thus, a grocery store can’t sell a loaf of bread for $2.001, because there would not be any way for the customer to give the grocer 1/10 of a cent, since there is no coin for that. The only way that the grocer can actually get $2.001 per loaf of bread is to require that the customer buy at least 10 loafs of bread for $20.01. But the customer is not likely to buy so many loaves of bread, so the grocer can’t sell the bread for $2.001.
However, because the quote currency is valued as a unit of the base currency, which makes it easier to compare different currency values and changes in currency values, and because a large amount of currency is usually traded, a smaller unit of measure is convenient in expressing currency prices. This smaller unit is called a pip, which is equal to .0001 of the base currency, for most currencies. In U.S. dollars, it is equal to 1/100 of a cent. Thus, 10,000 pips = 1 dollar. A well known exception to the value of a pip is the Japanese yen. Because the yen has much less value than the United States dollar, a pip is considered to be only 1% of the yen. (Currently, 120 yen ≈ $1.) Thus, most currency quotes are expressed by 4 significant digits, and the Japanese yen is expressed to 2 significant digits. The pip is the smallest value quoted by brokers and dealers. (Sometimes you will see quotes in the news that have 5 or 6 significant digits. These quotes were probably transacted by banks for large amounts of currency, but the smallest quote given by almost all forex brokers is the pip.)
Most investors buy currencies from market makers, or dealers, in that currency, who are commonly referred to as brokers. A dealer makes money by buying at one price and selling a little higher. When the dealer sells, the trader is buying, and when the dealer buys, then the trader is selling. The trader pays the broker's ask price (aka offer price), and the trader sells to the broker for the broker's bid price, and the difference between the prices is called the spread, which in currencies, is usually at least 4 pips. The bid price for the trader is always lower than the ask price, because that’s how forex dealers make money. If you want to buy currency, you have to pay the higher ask price, but if you want to sell currency, you have to sell it at the lower bid price. So if you were to buy currency, then immediately sell it back to the same dealer, the dealer would make money, and you would lose money. Thus, the spread is the transaction cost of trading currency.
For major currencies, the spread is usually about 3 to 5 pips or more, depending on the dealer. For less frequently traded currencies, or for major currencies during high volatility or low volume, the spread can be much greater. Although many brokers advertise 2-pip spreads, you will rarely see spreads less than 4 pips.
The actual transaction cost is determined not only by the spread, but also by the lot sizes of currency trades. Most regular accounts trade in lots of 100,000 units, and so a pip, when multiplied by the size of the account, will equal 10 units of currency. Most mini-accounts trade in lot sizes of 10,000 units, and so a pip will equal 1 unit of currency. If the quote currency is the USD, then a lot size in a regular account is $100,000 and each pip difference is $10. For a mini-account, a pip would be equal to $1. If the quote currency is other than USD, then the pip value would have to be converted if you wanted to know your profit or loss in USD. Since there are 10,000 pips to each unit of currency, and most lot sizes are either 100K or 10K, the total pip value can be found by the following formula:
Total Pip Value = Lot Size/10,000 x Conversion Rate
When the quote currency is the trader's native currency, then there is no need to multiply by the conversion rate for that currency.
The quote convention in forex is based on the fact that there are 2 quotes for any currency, the bid quote and the ask quote, both of which are expressed as a unit of the base currency. The symbols show the currency pair, and the numbers list the bid/ask quote for the quote currency (thus the name!).
Base Currency/Quote Currency Bid/Ask
The bid price is usually expressed to 4 significant digits after the decimal point, which represents the number of pips. The ask price is usually expressed as the significant digits that are different in pips from the bid price. For instance, you may see a quote such as the following:
This means that if you wanted to sell Euros for dollars, you would get $13,522.00 for 10,000 Euros, but if you wanted to buy Euros with U.S. dollars, then you would have to pay $13,524.00 to buy 10,000 Euros.
This quotation is expressed in terms of the dollar, but if the quote currency is the Euro, then it would be quoted this way:
This is equivalent to the above quoted price, but it is expressed in Euros per dollar rather than dollars per Euro. You can find the equivalent quote by dividing 1 by the quote. Thus, 1/1.3522 = 0.7395 (rounded) and 1/1.3524 = .7400. Converting it back: 1/0.7395 = 1.3522. Note that rounding errors makes the round trip conversion inexact, but you get the idea.
In forex trading software, currency quotes are generally displayed in 2 parts: the big figure and the dealing price. The big figure is the main price that is usually the same for both the bid and ask quotes. The dealing price is the last 2 digits of a currency quote that different for the bid and ask quote. Because it is more important in regards to trades, the dealing price is usually displayed in larger fonts in forex trading software.
Cross Currency Quotes
Any currency can be traded for any other currency. Cross currency quotes lists each currency in terms of the other currencies. Here is an example of key cross quotes of 4 major currencies:
You can see from this table that the quote for GBP/USD = 1.98244 and the obverse quote, USD/GBP = 0.50443. Note that the 1st column is the base currency while the 2nd row is the quote currency.
Fractional Pip Pricing
9/25/2007 - FXCM has introduced fractional pip pricing for their major currency pairs. So instead of seeing a quote of EUR/USD 1.401/04, you may see a quote such as EUR/USD 1.04014/038. While, theoretically, this should yield some savings to the forex trader, it may be more a marketing gimmick than anything else. It would be very difficult to tell if there were any real savings, because the average spread could be just as wide as before, except that you would be subtracting 5 digits instead of 4. Example: 1.44235-1.41235=1.4423-1.4123=3 pips. And even though there will be many differences of fractional pips, that does not mean that the average is better than before.
Fractional pip pricing would be most powerful on an organized exchange where the best bid/ask prices from all market participants are displayed, and would certainly result in narrower spreads. However, there is yet no organized exchange for currency. While FXCM advertises a No Dealing Desk, where quotes from forex traders is shown to a number of participating banks, I don't know how well this works. Someone would have to do a statistical analysis of spreads displayed by FXCM and competing forex dealers, and see if it results in narrower spreads.
For forex dealers, marketing is the name of the game, and certainly fractional pip pricing does sound good. Of course, 1 or 2 pip spreads that are widely advertised by forex dealers sound good, too. I have used FXCM, and they provide a very good service, but I rarely saw 2 pip spreads, even on major currency pairs such as EUR/USD. It's one thing to advertise such spreads, and another to actually see them and trade them.