Profiting in forex trading means buying low and selling high, although not necessarily in that order. To know how much you are paying or receiving from a currency transaction requires knowing how currencies are quoted.
Sources of Currency Quotes
There are no official exchanges for trading currencies; instead, currencies are traded in the over-the-counter market. Consequently, there is no official global exchange rate.
Currency exchange rates that are reported in the news and the Internet receive their quotes from various sources, but when a trader decides to do a transaction, the exchange rate will almost certainly be different, because dealers set their prices according to the buy and sell orders that they are currently receiving. Hence, different dealers will report slightly different rates, although arbitrage helps to remove major discrepancies of the different markets.
There are 3 types of major players in the foreign exchange market: reporting dealers, other financial institutions, nonfinancial customers.
- Reporting dealers include commercial banks, investment banks, and securities firms who transact with large corporations, governments, and other financial institutions, conducting trades for both their customers and for their own proprietary accounts. They also trade in the interdealer market. Many also serve as liquidity providers for brokers, offering bid/ask prices on currency pairs that are displayed to retail customers on the brokers' trading platforms.
- Other financial institutions are financial institutions that are not reporting dealers, including insurance companies, finance departments of large corporations, and investment funds, such as pension, hedge funds, and money markets. Also, central banks, since they sometimes conduct currency transactions to affect the exchange rate.
- Nonfinancial customers include all those not in the 1st 2 categories; mostly governments and corporations are the major players.
Reporting dealers generally supply the quotes for news organizations and websites, since they conduct most of the foreign exchange transactions, so they have a more accurate picture of the supply and demand for each of the individual currency pairs, which will yield a more accurate foreign exchange rate. Nonetheless, there will be slight differences in the exchange rate reported by different dealers. Almost all trades by reporting dealers are conducted electronically.
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). EUR/USD is the most commonly traded currency pair, composing almost 1/3 of all currency trades.
The currencies are unambiguously identified by codes standardized by the International Organization for Standardization (ISO). The ISO standard for currencies is ISO-4217, listing both the alphabetic code and numeric code of over 200 currencies, including any minor units of the currency, which is the smallest subdivision of the currency. However, the ISO uses a strange method for depicting the minor unit of a currency. It uses the log base 10 of the number of minor units equal to one unit of the currency. So, for instance, because 100¢ = $1, the minor code for USD is 2, because 102 cents = $1. In fact, most currencies have a minor currency code of 2.
The format of the 3-letter alphabetic 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.
In addition to currencies, 4 metals — called either forex metals or FX metals — can also be traded in forex accounts. Their symbol is formed by appending the element symbol with the letter X :
- Gold: XAU
- Silver: XAG
- Palladium: XPD
- Platinum: XPT
A 3-digit numeric code is also specified for each currency to facilitate the representation of the currencies in computer systems and to identify currencies for countries that do not use a Latin alphabet. For instance, USD has a numeric code of 840.
Format of Currency Quotes
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, etc. 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.
In forex, there is a standard in assigning the base currency to a currency pair, so when currencies are quoted, the currency with higher priority is the base pair. The priority of the major currencies is as follows:
- British pound (aka Cable)
- The GBP/USD pair is known as the Cable, because in the 19th century the price quote was transmitted via a transatlantic cable.
- Australian dollar (aka Aussie)
- New Zealand dollar (aka Kiwi)
- US dollar
- Canadian dollar (aka Loonie)
- Swiss franc (aka Swissy)
- Japanese yen
So websites and forex trading platforms will quote EUR/USD, not USD/EUR, and USD/CHF, not CHF/USD. These currencies are considered the major currencies — sometimes referred to simply as the majors — while all other currencies are considered minor currencies — sometimes simply called minors. Forex quotes of a major currency and a minor currency will usually list the major currency as the base currency.
However, in certain situations, other types of quotes may be more desirable, and the media may report different quotes. The main advantage of these different types of quotes is that the base currency or quote currency remains the same for different currency pairs, regardless of the currency priority. For instance, American forex customers would mostly be interested in American quotes, since they usually want to see the value of other currencies per $1. Currency futures in the US are also reported as American quotes. There are 4 major types of currency quotes:
- direct quote
- The base currency per unit of the other currency, i.e. Quote Currency/Base Currency
- indirect quote
- The number of foreign currency units per unit of the base currency — this is the way currency is usually quoted, i.e. Base Currency/Quote Currency
- American quote
- The number of USD per unit of other currency, which is a direct quote where USD is the base currency, i.e. USD/Unit
- European quote
- The number of foreign currency units — any foreign currency, not necessarily just the Euro — per 1 USD, so this is an indirect quote where USD is the base currency, i.e. Units/USD
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 measurement is convenient in expressing currency prices. This smaller unit is called a pip, which = .0001 of the base currency, for most currencies. In U.S. dollars, it equals 1/100 of a cent. Thus, 10,000 pips = 1 dollar. When USD is the quote currency, a pip is always equal to $10 for a standard contract, $1 for a mini-contract, and $.10 for a micro-contract. For US traders, a pip value in another currency must be converted to US dollars.
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 only 1% of the yen. 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.
However, larger transactions may be reported to 5 or 6 decimal places. Prior to 2005, exchange rates were expressed to 4 decimal places, equal to the number of pips. However, electronic trading has allowed easy conversion using 5 or 6 decimal places, where the last digit would represent 1/10 or 1/100 of a pip. For instance, euro conversion rules require at least 6 significant figures.
A term that traders sometimes use is called the handle, which represents a specific decimal place, so that if the handle changes, then that would represent a significant movement in the value of the currency. So if the euro was at 1.35886 per dollar, then the euro would be regarded to be at the 5 handle. If the euro changed to 1.33784, then it would be regarded to be at the 3 handle.
Most investors buy currencies from market makers, or dealers, in that currency, who are commonly called 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 minor 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 from a dealing desk broker.
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 × 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 expressed as the significant digits that differ in pips from the bid price. For instance, consider this quote:
EUR/USD 1.3522/24 or 1.3522/4
To sell Euros for dollars, you would get $13,522 for 10,000 Euros, but you must pay $13,524 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:
USD/EUR 0.7395/94 or 0.7395/4
This is equivalent to the above quoted price, but expressed as 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 and 1 ÷ 1.3524 ≈ .7394. Converting it back: 1 ÷ 0.7395 ≈ 1.3522; 1 ÷ 0.7394 ≈ 1.3524. 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, or the handle, is the last 2 digits of a currency quote that are different for the bid and ask quote. Because it is more important in regards to trades, the dealing price is, ironically, usually displayed in larger fonts than the big figure 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.