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Forex and CFD Basics

We always encourage our clients to obtain maximum information before starting trading. Please note that Forex and CFD trading involves significant risks. It is crucial to understand how the market works as well as the meaning of the specific trading terms.

Below you can find some basic information about the market and trading:

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Forex

Forex, or FOReign EXchange, is the exchange of one country’s currency for another country’s currency.

Example: Sam lives in the US and is traveling to Europe. Sam has USD and needs to buy EUR. The current exchange rate is 1.3000 USD for 1 EUR. Sam buys 1000 EUR by selling 1300 USD (1000 x 1.3000). This is a foreign currency exchange or Forex.

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The Forex Market

The forex market is a place where currencies are traded. To buy EUR with USD you need to go to a bank or a forex bureau and sell your USD for EUR. Each bank or money changer has its own rate. The forex market consists of all these banks and money changers; it is not just one special place or one exchange. The forex market is decentralized and it is huge, with a turnover of around 4 trillion USD a day. It is much bigger than the equity market and is extremely liquid and volatile.

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Trading

Trading involves buying or selling one asset in exchange for another asset.

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Online Trading

Online trading involves a trading process that is carried out via the Internet. Users can access online trading platforms on the Internet. They can see current market prices and make deals as well as oversee all their trading activity.

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CFD

A CFD, or a Contract For Difference, is an agreement between two parties to exchange the difference between the opening and the closing prices of a contract at the moment of the contract closure, with this difference multiplied by the number of units of the asset specified in the contract. A CFD is a derivative linked to the underlying asset price. It does not involve physical asset delivery. When you trade in forex online, you do not buy or sell real assets. If you open EURUSD long, you do not physically buy euros and sell dollars. You trade CFDs. You make a deal that, at the moment you close the deal, you will receive or pay the difference between the opening and the closing prices multiplied by the number of units.

Example: Sam opened 1 standard lot of EURUSD long (that is, Sam bought 100,000 EUR-versus-USD CFDs). At the time of Sam's purchase, the current rate was 1.3000. Sam has just closed and the closing rate was 1.4000. When he closed, Sam made a profit = (1.4000 - 1.3000) x 100,000 = 10,000 USD.

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Currency Pair

Currencies differ from other assets because they are traded in pairs. When you trade shares or gold, you buy or sell with money. With forex, you trade one currency against another currency: you buy one currency and sell the other. Therefore you are trading two currencies, or a currency pair, simultaneously.

Example: When you buy EURUSD, you buy euros and sell dollars.

Currencies in a currency pair are denoted by 3 capital letters according to the International Standard for currency codes - ISO 4217. The first 2 letters are the same as the country code (according to the International Standard for country codes, ISO 3166). And the third letter represents the currency name.

Example: USD = US dollar, where "US" = the United States and "D" = dollar.

Currency pairs are made up of the first currency - the base currency - and the second currency - the term (or counter/quote) currency. There is a common international practice regarding which currencies are base currencies and which are counter currencies in currency pairs based on the following specific priority rankings:

#

Name

Country

ISO Code

Nickname

1

Euro

Euro zone

EUR

The single currency

2

Pound sterling

Great Britain

GBP

Cable

3

Australian dollar

Australia

AUD

Aussie

4

New Zealand dollar

New Zealand

NZD

Kiwi

5

United States dollar

United States

USD

Buck, Greenback

6

Canadian dollar

Canada

CAD

Loonie

7

Swiss franc

Switzerland

CHF

Swissy

8

Japanese yen

Japan

JPY

Yen

These are the world's main currencies. Other currencies are generally quoted against one of the major currencies. 

Examples:

GBPUSD: GBP is the base currency and USD is the counter currency.

EURGBP: EUR is the base currency and GBP is the quote currency.

USDSEK: USD is the base currency and SEK (Swedish krona) is the term currency.

If currencies are quoted according to this practice, the quotation is "direct", if vice versa - "indirect".

Example: EURUSD, where EUR is the base currency and USD is the counter currency, is a direct quote while USDEUR is an indirect quote.

The most traded currency pairs in the world are called "majors". They occupy the largest share - about 85% - of the forex market. The majors are:

  • EUR/USD
  • USD/JPY
  • GBP/USD
  • AUD/USD
  • USD/CHF
  • USD/CAD
  • USD/NZD

Cross-currency pairs that consist of the main currencies e.g. EURGBP, EURJPY or GPBJPY are called "crosses" and are also actively traded.

Other currency pairs, where a non-main currency is traded against a main currency, are called "exotics"; e.g. USD/SGD (Singapore dollar) or USD/HKD (Hong Kong dollar).

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Long/Short Position

When you buy an asset, you are going "long". When you sell, you are going "short".

Example: Sam buys stock, so he has opened a long position.

When you trade currencies, you buy one currency and simultaneously sell another currency. So you are going long for one currency and simultaneously opening a short position for another currency.

Example: When Sam buys EURUSD, Sam is going long for EUR and going short for USD.

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Bid/Ask (Offer) Price

Quotes for trading instruments usually have two sides: the bid price and the ask (offer) price. The bid price is the price of an asset at which the market or broker is ready to buy from a trader (that is, the trader can sell, or go short, at this price). The Ask or Offer price is the price at which a trader can buy an asset.

Example: The quoted EURUSD rate at the moment is 1.3029/1.3030. This means that 1.3029 is the bid price - a trader can sell EURUSD at this price, whereas 1.3030 is the ask price - a trader can buy EURUSD at this price.

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Spread

The difference between the bid price and the ask price is the spread.

Example: The current rate for gold is 1750.1/1750.2. This means that the spread is 1750.2 - 1750.1 = 0.1.

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Pip

The pip is the smallest price increment.

Example: Currency pair prices used to have 4 digits after the decimal point (e.g. EURUSD at 1.2539), and 0.0001 was the smallest amount by which the price could change (e.g. from 1.2539 to 1.2540).

Now, however, prices can change by one-tenth of a pip, or by 1 fractional pip, also called a pipette.

Example: USDJPY was usually quoted with 2 digits after the decimal point, e.g. 77.21/77.23, and 1 pip = 0.01. Now you can see the following quotation - 78.513/78.524, where the smallest price change is 0.001 = 0.1 pips = 1 pipette.

So the pip traditionally was the smallest price increment - 0.0001 for almost all currency pairs and 0.01 for pairs with JPY as a quote currency. And despite the fact that a currency pair can now be quoted with more decimal places thanks to more precise pricing, the pip remains the same.

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Pip Value

To calculate quickly how much your position P&L would change in case of certain price movements, a Pip Value is used. The Pip Value shows the position P&L change if the price goes up or down by 1 pip.

 Pip Value = Position Volume x Counter Currency 1 pip

As a result, you get 1 pip value in terms of the counter currency.

Example: Position 1 lot of EURUSD. Pip Value = 100,000 x 0.0001 = 10 USD

However, it is more important to know the value denominated in your account currency.

 Pip Value in Account Currency = Pip Value / Account Currency-Counter Currency Rate

Example: Position 1 lot of EURJPY. Account Currency - USD. USDJPY = 80.00. Pip Value = 100,000 x 0.01 = 1,000 JPY. Pip Value in USD = 1,000 / 80.00 = 12.5 USD.

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Lot

A lot is a standard size of a transaction. It is measured in base currency units.

The common lot sizes are:

  • Standard: 100,000
  • Mini: 10,000
  • Micro: 1,000
  • Nano: 100

Example: 1 standard lot of EURUSD = 100,000 euro; 1 nano lot of EURUSD = 100 euro.

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Equity

Equity is the amount of money you have if you close all your positions. Equity equals the balance plus P&L:

 Equity = Balance + P&L

Example: Sam's balance is 2,000 USD. Before he opens any positions, his equity = his balance = 2,000 USD. Sam buys 1 standard lot of EURUSD. The price goes up and his P&L is 1,000 USD. Now Sam's equity = his balance + P&L = 2,000 USD + 1,000 USD = 3,000 USD.

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Margin

Margin is the amount of money required to open or maintain a position.

The initial margin required to open a position equals the position divided by leverage:

 Initial Margin = Position / Leverage

The maintenance margin requirement (Stop-Out Level) is the level below which the position is closed:

 Maintenance Margin = Initial Margin x Stop-Out Level

The used margin is the total amount of money required to open current positions.

The free margin is the amount available on your account to open new positions.

 Free Margin = Equity - Used Margin, where Equity = Balance + P&L

Example: Sam's account balance is 2,000 USD. His leverage is 1/100. Sam wants to open 1 standard lot of EURUSD. The current EURUSD rate is 1.3000. Stop-out = 10%.

Initial Margin = 100,000 EUR / 100 = 1,000 EUR (or 1% margin requirement) = 1,300 USD

In this example Sam needs to have 1,300 USD on his account to open 1 lot of EURUSD.

Maintenance Margin = 1,300 USD x 10% = 130 USD

When equity on Sam's account goes below 130 USD, the position will be closed automatically.

Used Margin = SUM (All Initial Margins) = 1,300 USD

Equity = 2,000 USD

Free Margin = 2,000 USD - 1,300 USD = 700 USD

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Leverage

Leverage is a gear or a multiplier required to open a position bigger than your deposit. In online forex/CFD trading leverage is the credit that a broker provides to a trader to increase the trader's open position and correspondingly the trader's Profit & Loss (P&L).

Example: Sam deposits 1000 USD into his account. Sam's broker provides him with a 1/100 leverage. The maximum position Sam can open equals his deposit multiplied by his leverage = 1000 USD x 100 = 100,000 USD. Sam's P&L is correspondingly multiplied by 100.

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Swap (Rollover)

If you open a position and do not close it by the end of the same day, your position will be rolled over to the next day. Rollover is achieved by two simultaneous deals: your position closure at the end of the day at a spot rate and the reopening at the beginning of the next day at a forward rate. This mix of two opposite deals in one operation is called a swap. The difference between the forward and the spot rates is called swap points.

The forward rate is based on the idea that amounts in both currencies are paid with an overnight interest rate. The difference between these two rates, or the Interest Rates Differential, results in positive or negative swap points.

 Forward Rate = Spot rate x (1 + interest of the quoted currency x days/base) / (1 + interest of the base currency x days/base)

 Swap Points = Forward Rate - Spot Rate = Spot rate x ((1 + interest of the quoted currency x days/base) / (1 + interest of the base currency x days/base)) -1) ? Spot Rate x (Interest Rates Differential) x days/base

 where

 Interest Rate Differential = Interest of the quoted currency - Interest rate of the base currency

Example: Sam buys 1 standard lot of EURUSD on Monday. The EURUSD spot rate is 1.25, the USD (quoted currency) interest rate is 1%, and the EUR (base currency) interest rate is 3%. Sam keeps this position until Tuesday.

Forward Rate = 1.25 x (1 + 1% x 1/360) / (1 + 3% x 1/360) = 1.249931

Interest Rates Differential = 1% - 3% = -2% annual

Swap Points = 1.25 x ((1 + 1% x 1/360) / (1 + 3% x 1/360) - 1) = - 0.00006944 or approx. -0.69 pips

Swap Points = 1.25 x -2% x 1/360 = -0.00006944 or approx.-0.69 pips

In this case Sam's position was closed on Monday at 1.25 and re-opened on Tuesday at 1.249931, i.e. 1 lot of EURUSD sold at 1.25 and bought at 1.249931 gave the result = 100,000 x (1.25 - 1.249931) = 6.94 USD

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Commission

Traditionally, unlike stock, commodities and other centralized markets/exchanges, there were no commissions paid in the forex market as the broker's fee was usually included in the spread. This was common practice for all market participants, including big banks.

However, developments in ICT led to the creation of Electronic Communication Networks (ECNs). At first ECNs were available for banks and big brokers, enabling them to trade with each other at the best prices available in their network. Each of these networks formed a market with its own pricing and spreads, charging a commission for its services as a technology provider. Later on, ECNs became available to smaller brokers and their clients.

Accounts with access to an Electronic Communication Network are called ECN accounts. On such accounts clients get very tight raw interbank market spreads and are charged a commission for the service.

Commissions on the interbank market are charged on a per-traded-volume basis. They are usually quoted in USD per 1 million USD traded volume. To calculate your deal commission, you need to determine your deal volume in USD, divide by one million, and then multiply it by the ECN commission value.

 ECN commission = Traded Volume in USD / 1,000,000 x ECN commission in USD per 1M USD traded volume

Example: Sam is buying 1 lot of EURUSD. The current EURUSD rate is 1.3000. The ECN commission would be 30 USD per 1M USD traded volume.

Keep in mind that deal volume is measured in the base currency terms. In this example, Sam's deal volume is 100,000 EUR.

The commission when Sam opens the deal = 100,000 EUR x 1.3000 /1,000,000 x 30 USD = 3.9 USD

If, for example, Sam chooses to close the deal at the same rate of 1.3000, the commission will be = 100,000 EUR x 1.3000 /1,000,000 x 30 USD = 3.9 USD

So in total, Sam will pay a commission of 3.9 USD + 3.9 USD = 7.8 USD

When you trade in MetaTrader 4, please keep in mind that due to system settings the whole commission is charged once at the order opening.
Some brokers offer STP/ECN accounts with the commission included in the spread, e.g. our MT4.VAR. account. Such accounts are designed specifically for clients who are used to commissions not being charged separately and with all broker fees included in the spread. The trading costs are the same as for the MT4.ECN. accounts.

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