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8 common terms to be familiar with before trading Forex

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Online Forex Trading is growing in Canada, but there are a lot of risks associated with it.

Understanding basic terminology can be your first step towards risk management and effective trading. Forex trading has some important terms that are the building blocks of trading and we will discuss them below.

#1 Spread

The spread is the difference between the Bid and Ask price of a currency pair. In Forex, currencies are traded against each other in pairs example EUR/USD where the first currency (EUR), is the base currency; and the second currency (USD), is the quote currency.

When going long, you sell the quote currency to be able to buy the base currency. However when going short, you sell the base currency in exchange for the quote currency.

If you see a quote like EUR/USD = 1.6023/1.6025, the price that comes first (1.6023) is the Bid price, while the second price (1.6025) is the Ask price.

The price the broker is willing to sell the base currency to you for, is known as the Ask price, but the actual market value of the base currency is called the Bid price. This means if you take the base currency elsewhere to sell, they will buy it at the Bid price. The bid price is always lower than the ask price so the broker can make a profit.

For example, you want to go long on EUR/CAD and Bid/Ask price on the Brokers website is 1.1552/1.1557 it means the broker is willing to sell 1 Euro to you for 1.1557 CAD, while the real market value of 1 Euro at the time is 1.1552 CAD. In this case the spread = 1.1557 – 1.1552 = 0.0005 or 5 pips when you ignore the zeros.

#2 Forex Broker

A forex broker is a financial service firm that gives you access to their trading platforms. They serve as a link between you, and networks of banks that have access to foreign exchange liquidity. You cannot trade forex online without opening an account with a  broker.

Online trading in Canada is regulated by The Investment Industry Regulatory Organization of Canada (IIROC) and they issue licenses to forex brokers who they deem fit and proper to manage client funds.

There are only a few forex brokers that are regulated in Canada and hold a dealer license with IIROC. Any broker not licensed by them is not safe to deal with because the IIROC will move for liquidation should the broker become insolvent. They will also ensure your funds deposited with the broker are returned to you via the Canadian Investor Protection Fund (CIPF) mechanism.

To avoid unsafe forex brokers, ensure you verify their registration status from the IIROC by checking their regulated dealers. It is not uncommon to see traders sign up with more than one broker so as to compare their fees and general services.

#3 Margin

Margin is a small amount of capital or initial investment a trader will need to open and maintain a position. It is not a fee but is a portion of the trader’s account balance that serves as a collateral or good faith deposit.

Margin is usually expressed as a percentage of the actual size of the Forex position. You will have to deposit the required margin into your margin account to be able to open a position.

For example, to open a position that has an actual size of $100,000, a margin of 1% will mean you will only have to deposit $1,000 into your margin account to open the position. The remaining 99% or $99,000 will be lent to you by your forex broker.

The amount of margin can differ depending on the currency pair and the broker. Margin amplifies gains, but can also amplify the impact of loss.

#4 Leverage

Leverage and margin are related in that they share an inverse relationship. If your broker grants you a leverage of 1:100  on a currency pair it means:

  • The margin you will be required to deposit while your broker lends you the balance will be Margin = 1/Leverage = (1/100) % = 1%.
  • With $1 you can lift/carry an order 100 times large

Brokers allow you to access leverage through margin trading. In a forex trade, currency movements are measured in pips and are usually small. For example, if a currency pair of CAD/EUR moves 100 pips from 1.8500 to 1.8600, the difference is just 1%.

To make tangible profits, traders often trade with a large sum, and this is where leverage comes to play. The higher the leverage the higher the potential profit or loss.

As a result of the IIROC regulation in Canada, leverage can be as high as 50:1 (at Oanda for example), depending on the currency pair & CFD instrument. Extremely high leverage increases your risk exponentially & you could get a margin call if the price if moving against you & you don’t have enough balance in your account.

#5 Margin Call

A margin call is a notification from your broker to inform you that you have to deposit more money in your margin account to continue trading or risk having your open positions closed without recourse to you.

Margin calls are usually associated with leveraged trades. It occurs when your ‘margin level’ falls below the broker’s maintenance margin requirement.  (Amount of money required to keep the position open).

If you have $10,000 in your margin trading account and your broker’s maintenance margin requirement is 25% it means that should you decide to take out $4,000 to open a trade your margin level is:

Margin Level = (Equity/Used margin) x 100 or ($10,000/$4,000) x 100 = 250%

If you keep losing in your trades, you equity keeps getting depleted and your used margin keeps increasing, so your margin level keeps falling.

When your margin level falls to 100% you are barred from placing new orders, and when it gets close to 25%, a margin call is placed to you.  If you don’t comply with a margin call, all your open positions are closed at the current market price even if it means doing so at a loss. You may also be charged transaction fees for closing the positions.

When trading Forex, a margin call is an indicator that the trade is not going in your favour. Losing a leveraged trade is bad for business, because you may end up owing your broker.

A margin call is not only bad for traders but brokers as well. To avoid getting a margin call, it is usually advised to go for lower leverages like 10:1 or even lower.

#6 Lot Size

Lot is the number of currency units that are bought or sold in a Forex trade. It is a unit for measuring transaction amounts.

There are:

  • Standard lot: 100,000 units
  • Mini lots: 10,000 units
  • Micro lots: 1,000 units
  • Nano lots: 100 units

For instance, to open an order for one standard lot of EUR/USD with an exchange rate of 1.0623, the contract sum will be (100,000 units x $1.0623) = $106,230  

#7 Market Order

A market order is an order to purchase or sell a currency pair at a price specified by you or at the next available market price once the price reaches a specified point. Some common market orders are stop loss orders, and stop limit orders.

For stop loss orders, if you are long on EUR/USD with an exchange rate of 1.0623 you can manage your forex trading risk by placing a stop loss at 1.0620. The result will be that once the exchange rate dips past 1.0620, your currency will be sold off at the prevailing market price to prevent further losses. However for stop limit orders, instead of selling off your currency at the prevailing market price, you can specify the least price at which your position will be closed.  

#8 Volatility

Volatility is the measure of the rate at which a currency’s value changes over some time. A currency can have high volatility or low volatility depending on how much its value fluctuates. During periods of high volatility, you may witness highest highs and lowest lows. Moderate volatility is good since prices have to change for you to make a win but too much of it can be risky.

Trading with currencies that have high volatility means more trading risk. However, some traders who love to take risks like to trade with such currencies because a large price change in the value of the currency may result in more profit, but this is also very risky.

When volatility is high you may want to set your stop loss far from your entry price to avoid getting stopped out frequently.

Measuring volatility can be difficult because volatility is unpredictable. However, with the help of technical analysis charting indicators like: Average True Range (ATR), Bollinger Band, and the CBOEs VIX index, volatility can be measured for various markets.

Final Word

Understanding the common terms used in Forex can help you understand the figures and terms you see on your trading platform. But to effectively manage risk, you must learn and understand the Forex market.

Other articles from mtltimes.ca – totimes.ca – otttimes.ca

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