Before we get into the nitty-gritty of analyzing the foreign exchange market through various tools and techniques, we have to know what the various terms mean.
Here is a quick overview of some of the important terms in the foreign exchange market and what they represent.
The Spot Transaction
You may have often heard of spot transactions, which refer to an outright transaction. Even in the foreign exchange market, a spot transaction refers to a similar transaction. When one currency is straight away traded for another foreign currency, it is called a spot transaction.
The spot rate used to conduct the transaction would be the prevailing market rate or what is called the ‘cash’ rate. However, even if the transaction is concluded on the spot, the settlement need not be made then and there. Typically, the payment is made on the second business day after the date on which the spot transaction was carried out between the two parties.
A spot transaction is a useful transaction for an investor or a speculator, allowing him or her to take advantage of any sudden fluctuations in a usually strong currency. Also, since the settlement need not be made that day, they can conclude a transaction on the same day as the changes happen, to take immediate advantage of the situation and then make the payment a day later.
Bid and Ask
As is true of any financial market, there is a selling price and a buying price for every commodity. These prices are almost always determined by the market conditions.
In the foreign exchange market as in other financial market, a market maker has to quote both prices at the same time for his customers. In other words, he has to quote a price at which he is willing to buy a certain currency pair (the bid) and he has to quote the price at which he is willing to sell a certain currency pair (the ask).
The difference that one can see between the bid rate and the ask rate is indicative of the level of liquidity that exists in a certain currency. Some of the major currency pairs traded in the foreign exchange market are Euro-US Dollar (EURUSD), US Dollar-Japanese Yen (USDJPY) and Pound-US Dollar (GBPUSD). A high liquidity in the currency also means that you can always find a buyer to buy the currency you are selling and a seller who is willing to sell you the currency at the actual market rates.
One also hears of the bid-ask spread which is the difference between the bid price or buying price for the currency and the ask price or selling price for the currency.
Base Currency and Counter Currency
Since every transaction in the foreign exchange market involves a currency pair, in other words, since it involves two currencies, it can get confusing to remember which is the base currency and which is the counter currency. As we had mentioned earlier, every currency pair being traded on the foreign exchange market is denoted by AAA/BBB where AAA and BBB are internationally recognized three-letter codes for the individual currency.
Then, BBB or the currency in the denominator is the base currency and AAA or the currency in the numerator is the counter currency. As you can now understand, when the counter currency increases, it leads to the strengthening of the base currency and it is now more expensive to buy that particular currency. Conversely, when the counter currency decreases, it leads to the weakening of the base currency and it is a lot cheaper to buy that particular currency.
However, in trading lingo, the base currency is always mentioned first and the currency pair is typically represented as BBBAAA. So a quotation for EURUSD indicates that the Euro is the base currency and the US Dollar is the counter currency.
Understanding How Quotes Work
In the foreign exchange market, trading is usually done based on how much is needed to sell or buy a particular base currency. A trader will typically quote a figure like 1.2733 / 35 for the EURUSD. Let us now understand what this quote means.
The figure on the left is your sell quote or the trader’s bid quote and is the price at which the trader is willing to buy 1 Euro from you. As you can see, this means for every 1 Euro you sell to the trader, you will get US Dollar 1.2733.
The figure on the right is your buy quote or the trader’s ask quote and is the price at which the trader is willing to sell 1 Euro to you. So, for every Euro you want to buy from the trader, you will have to pay him US Dollar 1.2735.
Getting To Know The Pips
As you would have observed in our previous example, the difference in the bid quote and ask quote lies in the fourth decimal place. This is the smallest unit by which the prices for the currency pair may vary and is known as the basis point or more popularly as ‘pips’. In this case, the pip is equivalent to a hundredth of one percent.
Euro Cross Rates
The Euro cross rates are currency pairs that have the Euro as the base currency and another foreign currency as the counter currency. Popular Euro crosses are EURUSD, EURJPY and GBPEUR. Those currency pairs that involve neither the US Dollar nor the Euro are merely called cross rates.
There are hundreds of currency pairs in the foreign exchange market and consequently hundreds of cross rates. However, most of them have a problem of low liquidity. Further, since the introduction of the Euro, the number of cross rates whose liquidity was assured have come down and to a certain extent been replaced by Euro crosses.
FOREX Terms and Techniques