With the rise of trading over the internet, the smaller investor is increasingly participating in the foreign exchange market which was the realm of big institutions previously. There are dozens of online brokerage houses and spread betting firms which give you the ability to trade a large variety of major and minor currency pairs.
Before we go any further we need to discuss some forex basics.
The Market Quote
For each currency pair there will be a live market quote which is based on levels in the interbank market. The market quote will always have 2 numbers: a bid (buy) price and an offer or ask (sell) price. The bid is the highest quoted price that a participant in the market is willing to buy at. The ask price is the lowest price a market participant is willing to sell at.
Therefore, if for a given quote you want to buy a currency immediately, you must do so at the current ask price. Your order is ‘filled’ at the ‘market price’ and here you are ‘lifting the offer’.
Likewise, if you wish to sell at the market price, you must trade at the bid price. You are ‘hitting the bid’.
So taking the EUR/USD as an example:
The quote is currently 1.1903-1.1906
We can buy the euro at 1.1906 and sell the euro at 1.1903.
Since euro is quoted first it means 1 euro = $1.1903-$1.1906. So if the price goes up it means the euro is getting stronger (and the dollar weakens). If the price goes down, the euro has weakens and so the dollar gains strength.
The difference between the 2 prices is known as the spread. The spread in this case is 3 'points'/'ticks'/'pips', that is .0003, since .0001 is the minimum movement allowed.
Let’s look at another major currency cross – the Dollar-Yen.
USD/JPY is trading at 117.40-117.44
This time the USD is quoted first so here 1 dollar can be ‘purchased’ for 117.44 yen. If the figure increases, then the dollar strengthens (thus the yen weakens) and vice versa. We can sell the dollar at 117.40 yen.
We don’t have to send an order at the market price every time. We can send a limit order to market which will only trade when a bid or offer price matches our limit sell or buy price, respectively.
So if we are looking to buy USD/JPY but don’t want to pay 117.44, we can put a limit order for say 117.41 which will become the best bid in the market, until it is taken out by someone hitting that bid. However there is always the risk that 117.41 might not trade and the market will run up higher against you - so you will miss out on your trade price.
If you think the market will trade lower you could put in a bid of 117.25 say, but you will have to sit and wait to see if the market fills you.
Because the forex market is so liquid you should be filled if you put a limit order between the bid and offer price.
Also note that major FX spreads are generally quite narrow so it should not matter too much whether you miss out on those 3 ticks - especially if you are looking for movements of 100 ticks or more.
Quick Tip: Many people get a bit confused at forex quote price changes in terms of which currency is appreciating/depreciating. A simple rule of thumb is this : If the price goes up, the first quoted currency strengthens; if the price goes down the first quoted currency weakens. By logic then, the second quoted currency will do the opposite.
Currencies move relative to each other, so when we say the dollar weakens, we mean it weakens against a specific currency, not necessarily all currencies. But because currencies are inter-related, the cross pairs will adjust in value. So a big movement in EUR/USD will have an effect on USD/JPY and EUR/JPY so that the exchange rates remain consistent.