An Introduction to Forex
We love Forex (as you might expect – in fact, it’s in our name), it’s such a fascinating topic!
We have already discussed the history of forex (to be honest, we are kind of history buffs) but there is still so much more to cover.
And the very purpose of our articles is to instill some industry knowledge in the minds of our readers, because at Kuda FX, we believe that knowledge is power.
Therefore, in an effort to educate (and help) our valuable clients (and anyone else) itching to find out a little more about forex, we thought we would shed some light on basic terminology that you may come across (enabling you to fully grasp everything forex related) as well as how the value of a currency is determined – is it just typical supply and demand or is it based on other factors?
Let’s dive in, shall we?
Getting to grips with some basic terminology
First off, let’s deal with the broader terms you may come across –
According to the Corporate Finance Institute, foreign exchange (also referred to as forex or FX) is –
“the conversion of one currency into another at a specific rate known as the foreign exchange rate”
Elaborating on the above, we come to the term foreign exchange rate. An “exchange rate” according to Britannica is –
“the price of a country’s money in relation to another country’s money. An exchange rate is “fixed” when countries use gold or another agreed-upon standard, and each currency is worth a specific measure of the metal or other standard. An exchange rate is “floating” when supply and demand or speculation sets exchange rates (conversion units)”.
Or more simply put, it’s the rate at which you exchange one currency for another. That’s it. The exchange rate indicates how much of one currency you need if you want to purchase 1 unit of another currency. Simple as that.
The foreign exchange market, the marketplace – if you will – is the next stop.
Investopedia defines the FX market as –
“an over-the-counter (OTC) global marketplace that determines the exchange rate for currencies around the world. Participants in these markets can buy, sell, exchange, and speculate on the relative exchange rates of various currency pairs.”
And in quite simple terms, the above terms boil down to the following – foreign exchange is the exchanging of one country’s currency (let’s say the ZAR), for another country’s currency, (let’s say the USD) for a price (the exchange rate) which is determined by the Forex market.
With those main terms done and dusted, let’s move on to some other terminology you may come across –
- A Currency Pair, this may sound complicated but it essentially boils down to this – to trade in forex, you need a pair of currencies i.e. you are trading one currency for the other, with one currency being bought and the other one being sold. And that is a currency pair. Together these currencies make up an exchange rate.
- A Base Currency is the first currency in a currency pair, also referred to as the nominator (or top number). For example, when trading the USD/ZAR pair, the USD is the base currency.
- A Quote Currency is the second currency in a currency pair, also be referred to as the denominator (or bottom number). When trading the USD/ZAR, the ZAR is considered to be the quote currency.
- A PIP is generally the smallest increment or price change of a given exchange rate. Pips are used to measure the sometimes-incremental movement in a currency pair. Pip prices are not fixed and can change (moving up or down) depending on the timing of the trade or the amount that is being traded.
- A Lot refers to the minimum amount of currency that forex is usually traded in i.e. forex is traded in an amount called a lot.
- An Ask Price is also known as an offer price is the price a trader will buy a currency pair at.
- The Bid Price is the price a forex trader is willing to sell a currency pair for.
- A Basis Point is the term or measurement used to describe the lowest possible change in the price of forex.
- A Position doesn’t refer to how you sit or stand but rather the trade that you hold open during a certain period of time. A position may also be a long position wherein you purchase the base currency or a short position where you sell the base currency.
- A Stop Loss is a risk management tool that allows a position to be closed once it reaches a specific pre-set price. This can protect against further losses on an open position if prices continue in an unfavourable direction for the investor.
- Leverage – when trading in forex you may not always have the means to gain exposure to larger amounts of currency. By leveraging, your forex trader (like Kuda FX) lends you the money so that you can trade larger amounts with less capital. The amount that you are able to leverage will depend entirely on your broker and their flexibility. The leveraged amount can also be influenced by what type of account you open, what the leverage for that particular account type is, and how much leverage you may actually need.
- A Margin is the minimum amount of funds, expressed as a percentage, that you will need if you want to open a position and keep it open.
- A Margin Call is when a forex dealer requests additional funds or other collateral on a position that is not moving in the favour of the investor.
- Equity is quite simply the total amount of currency in your trading account, taking into account all of your profits and losses.
- Gapping occurs when the opening price of a currency is significantly above or below the previous day’s close. With the kicker being that there was no trading activity in between the close and the opening of markets. This means that a stop loss order could be filled at a price different from the pre-set price.
- A Commodity is a raw material or agricultural product that can be bought and sold, including oil, coffee, wheat, copper and most definitely gold (be mindful of gold however as it can also be considered a currency. Remember, gold is not a consumable like some other commodities. In other words, once gold is mined it remains in the world, it doesn’t get “used up”. Which is why some define gold as a type of currency. Read here for more info on this topic).
There are many more terms and buzz words used in the forex trade. But we believe the ones listed above should cover most of what you need to know.
However, should there be any other term that you come across, please feel free to get in touch with us and we would be happy to explain the meaning behind the term or how it applies to you or your investment.
Kuda FX has you covered!
How is the value of a currency established?
Having tackled some of the basic forex terminology, let’s get into how the value of a currency is established.
According to the Corporate Finance Institute, Britannica and Investopedia, the value of currency is established through the aggregate of supply and demand. Now supply and demand can be (and often times is) influenced by a number of various factors, including interest rates (both its increase and decrease depending on the demand for money or credit), inflation and capital flow.
But the most common way to value currency is through exchange rates (remember we spoke about that above?).
Now exchange rates can either be fixed or they can be floating. We promise this is a lot simpler than it sounds!
- A fixed exchange rate is set to a pre-established standard such as gold or another commodity and each unit of currency corresponds to a fixed quantity of that standard.
- A floating exchange rate involves letting the foreign exchange market determine currency value with respect to the supply and demand of other currencies. It is not necessarily backed by a resource like gold or oil (like a fixed exchange rate is). Countries under a floating rate system may experience higher exchange rate volatility but may also benefit from exercising more autonomy over their economic policies and trade activities, enjoying higher liquidity. After the failure of the gold standard and the Bretton Woods Agreement (you can read a little more about this in our previous article), the floating exchange rate became the most commonly accepted exchange rate.
In fact, many of the world’s major currencies currently use a managed floating exchange rate. This means that each currency’s value is affected by the economic actions of its government or central bank (RBA, Britannica). And as we all know that can either be a positive thing or a negative one, depending on a country’s government.
We have tried our utmost to set out the basic forex terminology and have tried to set out how the value of currency is established. As straightforward as we possibly could. However, as with most things in life, it’s not always that easy – there are so many factors that can influence the value of a currency and hence determine the exchange rate.
So, while we encourage the gaining of knowledge, we also advise you to get in touch with a forex professional, like our team at Kuda FX who would be happy to explain the above concepts in further detail or provide any other assistance you may require with your specific forex needs.
In fact, if you have any queries on the information we have set out above, please feel free to get in touch with us. We cannot wait to help you with all your forex needs!