It’s time to acquaint yourself with a few terms and concepts that are fundamental to Forex.
In this article we will be covering the following:
- Currency Pair, Cross Pairs, Base Currency and Quote Currency
- Bid Price and Ask Price
- Lot and Contract Size
- Pip, Point, Point Size and Point Profit
- Leverage and Margin
- Balance, Equity and Free Margin
- Profit and Loss
- Margin Level, Margin Call and Stop Out
Currency Pair, Cross Pairs, Base Currency and Quote Currency
Currency pairs can be defined as the currencies of two countries combined together for trading in the foreign exchange marketplace. Some examples of currency pairs can be EURUSD, GBPJPY, NZDCAD, etc.
A currency pair that does not contain USD is known as a cross pair.
The first currency of a currency pair is called the "base currency", and the second currency is called the "quote currency".
Bid Price and Ask Price
Bid Price is the price at which a broker is willing to buy the first named (base) of a currency pair from the client. Subsequently, it is the price at which clients sell the first named (base) of a currency pair.
Ask price is the price at which a broker is willing to sell the first named (base) of a currency pair to the client. Subsequently, it is the price at which clients buy the first named (base) of a currency pair.
Buy orders open at Ask Price and close at Bid Price.
Sell orders open at Bid Price and close at Ask Price.
Spread is the difference between the Bid and Ask prices of a particular trading instrument and also the main source of profit for market maker brokers. The value of spread is set in points.
Lot and Contract Size
Lot is a standard unit size of a transaction. Typically, one standard lot is equal to 100,000 units of the base currency.
Contract size is a fixed value, which denotes the amount of base currency in 1 lot. For most instruments in forex, it is fixed at 100,000.
Pip, Point, Point Size and Point Profit
A pip is the value of price change in the 5th decimal, while point is the price change in the 4th decimal.
Derivatively, 1 point = 10 pips.
For example, if the price changes from 1.11115 to 1.11135, the price change is 2 points or 20 pips.
Point size is a fixed number which denotes the position of the point in the price of an instrument. For example, for most currency pairs like EURUSD where the price looks like 1.11115, the point is at the 4th decimal, thus the point size is 0.0001.
Point Profit is how much money a person will earn or lose if the price were to move by one point. It is calculated by the following formula:
Point Profit = Number of Lots x Contract size x Point size.
Leverage and Margin
Leverage is the ratio of equity to loan capital. It has a direct impact on the margin held for the instrument traded on. Exness offers up to 1:Unlimited leverage on most trading instruments on MT4 accounts.
Margin is the amount of funds in account currency which is withheld by a broker for keeping an order open.
The higher the leverage, the lesser the margin.
You may read more about the relationship between leverage and margin here.
Balance, Equity and Free Margin
Balance is the total financial result of all completed transactions and depositing/withdrawal operations on an account. It is either the amount of funds you have before you open any orders or after you close all open orders.
The balance of an account does not change while orders are open.
Once you open an order, your balance combined with the profit/loss of the order makes for the Equity.
Equity = Balance +/- Profit/Loss
As you already know, once an order is opened, a part of the funds is held as Margin. The remaining funds are known as Free Margin.
Equity = Margin + Free Margin
Profit and Loss
Profit or Loss is calculated as the difference between the closing and opening prices of an order.
Profit/Loss = Difference between closing and opening prices x Point Profit
Buy orders make a profit when the price moves up while Sell orders make a profit when the price moves down.
Buy orders make a loss when the price moves down while Sell orders make a loss when the price moves up.
Margin Level, Margin Call and Stop Out
Margin level is the ratio of equity to margin denoted in %.
Margin level = (Equity / Margin) x 100%
Margin call is a notification sent in the trading terminal denoting that it is necessary to deposit or close a few positions to avoid Stop Out. This notification is sent once Margin Level hits the Margin Call level set for that particular account by the broker.
Stop out is the automatic closure of positions when the Margin Level hits the Stop Out level set for the account by the broker.
To find out the Margin Call and Stop Out levels for the various account types, you may refer to this article.