Pips are Not Only Fruit: An Introduction to FX Trading

Editor’s note: We’ve been researching FX trading – and its cousins spread betting and contact for difference (CFD) for a good while now. John has been dabbling, with some success, as well. Still, FX trading is a ‘high entry’ endeavour: it’s specialised, demands varied knowledge, needs level headedness, understanding of technology and nerves of steel. FX trading is also a ‘high entry’ endeavour because there are risks involved; and while this may not be higher than the ones involved in other kinds of investing, they are certainly not as easy to grasp and/or control. This is why, we decided to write a guide to FX trading; this is the first in a series of posts.

‘Do you know how many pips have I made today?’

I stared at John with complete lack of understanding. Has he been eating grapes and collecting the pips? What for?

No, you see. He was telling me about his dabbling in a bit of spread betting. He’d already tried contract for difference (CfD) last year but back then he was talking pounds and pence; none of this pips business.

This is when it really hit me: I am a personal finance blogger who writes about this kind of thing. Still, when faced with ‘pips’ I had very vague idea what John was talking about.

So, the chances are that most people who could be interested in learning about FX trading, spread betting and CfDs will be face with the jargon; and most will never be able to get beyond it.

This is why, in this introduction to FX trading we’ll do some jargon busting together. If you already know the basics (like the jargon of spread betting, for instance) go do something useful. Don’t miss the next post though – this won’t be a ‘what is it’ guide but ‘how to do it’ one.

Let’s get to grips with some terminology now.

What is FX?

FX is short for foreign exchange – changing one currency into another.

Historically nations have defined their own currencies such as the dollar, the British pound and the German deutschmark (though this is history now).

While at various times in history, these currencies have been convertible into some token such as a rare metal (gold), diamonds or some useful commodity, since the First World War, currencies have been just promises to buy or sell.: all is fine as long as the promises are kept.

These are known as Fiat currencies and the only thing that is behind them is the trustworthiness of some authority (government, national bank etc.).

One thing is sure – with a sovereign Fiat currency, a country can never run out of money!

Why do we need FX?

If a country with its own currency doesn’t trade with any other country with a different currency, we would never need to exchange currencies.

But where trade occurs between countries, for example to buy food or sell manufactured goods, both buyer and seller need to know what the price is in their own currency so an exchange rate has to be calculated. This is hard with Fiat currencies.

During the Second World War, the Bretton-Woods agreement made the US dollar a sort-of gold standard where the dollar was guaranteed to be worth a certain amount of gold. Individual currencies had a fixed exchange rate against the dollar so all countries could trade.

From to time, there would be an ‘adjustment’ in one currency vis-a-vis the dollar, generally a devaluation. The Bretton-Woods arrangement continued until 1971 when the US, burdened in part by the Vietnam War (not to mention the space programme and competing with the Soviet Union), unilaterally withdrew from the agreement.

For some time, the old rates of exchange held but gradually currencies were allowed to float, the theory being that the market would set the rate.

What is ‘the market’?

In the past, it was a series of people who put together deals so that the exchange could take place.

Of course the deals were never exact – if you wanted something that cost so many dollars, the broker (acting for you) would have to call his contacts (market makers) to see how many dollars they had and what price they would give him, for example, in pounds.

Of course, countries and large businesses and particularly banks deal in millions or billions of dollars, pounds etc.; so this could be all very messy – sometimes trades would be made up of a large number of small deals.

Technology rode to the rescue and very soon, these deals were done via a computer. Even so, there was a substantial cost to any deal as all the intermediaries made a small charge.

As time has rolled on, the volume (i.e. the amount) of foreign exchange has mushroomed – currently something like 6 TRILLION dollars A DAY are exchanged! That’s $6,000,000,000,000 a day! (I know, I have problem with these kind of numbers as well.)

Surely this is more than we need?

Certainly it is – it is far more than the actual amount required to settle bills. Most of it is entirely speculative as purely by guessing right that a currency will go up or down, a trader can ‘manifest’ a lot of money – out of nothing!

Aren’t such actions parasitic?

Not really – the size of the speculative market means two things.

Firstly you can always get a price for a currency because someone somewhere will be prepared to buy it.

Secondly because there will be a number of such players, you can get a very competitive price.

This means that money can flow easily and readily where needed – and that the cost of transactions is minimised through competition. It all eases trade – well that’s the theory anyway although some people disagree.

And of course this also means that can ‘buy’ a currency forward – to be sure you can afford that retirement house in France, for example. While the market may move in your favour, you can take an insurance against it moving in the other direction so for a small(ish) sum you can buy a call option, which you don’t have to execute.

What is spread betting?

Spread betting is when you bet on whether something – including a traded currency – will go up or down; and your win is determined by the accuracy of the wager. It is not binary – spread betting is not only about whether or not the thing will go up.

Spread betting is illegal in the US. In the UK, spread betting is regulated by the Financial Conduct Authority (rather than by the Gambling Commission). Interestingly, the profit from spread betting is not taxed.

What are liquidity and spread?

If money (in this case, change from one currency to another) flows easily, it is said to be liquid.

And as the cost of the transaction is kept down, the difference in price between buy and sell (ask and bid) is minimised and this is the spread.

What is a pip (or a point)?

A pip is roughly 1/100% of the exchange rate quoted – frequently the 4th and 5th decimal place but that depends on the currency.

At the moment, the Euro is trading at about 1.0752 to the dollar so a Euro would cost you perhaps 1.0753 dollars; if you sell it, you would only get 1.0751 dollars. This would be a spread of 2 pips (or points).

In fact a better rate for Euro-Dollar (EUR/USD) would be less than one pip so generally the 5th decimal place is required. Euro-dollar is the most heavily traded currency so it is most liquid and has a smaller spread (these two go together).

What is an instrument?

It’s a fancy name for something that you buy or sell – but not like a bunch of bananas, a house or a car. It could be anything such as a share, an option to buy or sell a share, a mortgage or a foreign currency.

Where you are not dealing in the actual instrument (e.g. you are gambling on a price), you are working with a derivative of the object which could just be its price for example. So you may be trading Euros for dollars, in which case the instrument is EUR/USD which is the number of dollars that equate to one Euro.

What is volatility?

Volatility is a measure of how a particular instrument varies over the day – or over a longer time.

Highly volatile instruments enable some traders to enter and exit the market repeatedly so that they make a small profit each time. This sort of trading is called scalping and is generally done automatically by computer algorithms.

What is going long?

When you go long, you are expecting the price of something to increase so you buy it and wait for it to go up; then sell it.

This is exactly what people are doing when they buy shares. The profit is in the difference between the price at which you sell and the original price at which you bought.

What is short selling?

Strictly it’s not selling at all – it is borrowing something, selling it, buying it back when the price has dropped then returning it to the original owner. The profit is in the reduced price required to buy the same amount back.

What is a position?

Because you can make a profit both buying and selling, we don’t speak about buying or selling but ‘opening a position’.

That can be a long position or a short position depending on whether you are expecting the price to go up or down. And instead selling or buying at the end, we speak about ‘closing a position’, hopefully to take a profit.

Finally…

Fortunes have been made by FX trading.

George Soros – this is the guy whose foundation paid the grant that brought me to the UK – made $1 billion in 1992 when he borrowed a lot of money and shorted the British pound.

Stanley Druckenmiller made $1 billion betting that the Deutschmark will rally after the fall of the Berlin wall.

Telling you this is a bit like telling you that Warren Buffet regularly beats the market. He does! But we both know that most people don’t make much money. Worse: some of them lose money.

FX trading, just like any other investment, ought to be handled with care.