When you buy and sell currencies, you do so by buying one currency in exchange for another currency – that is the reason why currencies are quoted in pairs such as EUR/USD, AUD/USD or USD/JPY. Before you start trading the Forex market it helps to understand how the Forex price quotation system works.
How to read a Forex Quote
Normally, all currencies are quoted in pairs where each currency is abbreviated into three letters. For example, the most common currencies use the following abbreviation system:
- US Dollar abbreviation is: USD
- Australian Dollar abbreviation is: AUD
- Euros abbreviation is: EUR
- Japanese Yen abbreviation is: JPY
- Swiss Franc abbreviation is: CHF
- British Pound abbreviation is: GBP
A Forex quote will always involve two currencies; where the currency on the left represents the base currency while the currency on the right represents the counter currency which is also referred to as the quote currency.
Forex Direct Quote vs. Indirect Quote
We can distinguish two types of currency quotes: the direct quote and the indirect quote system. If the second currency or the quoted currency of a currency pair is the domestic currency, then we’re dealing with a direct quotation system.
If the first currency or the base currency of a currency pair is the domestic currency, then we’re dealing with an indirect quotation system.
For example, if we’re looking at the Australian Dollar as being the domestic currency and the US Dollar as the foreign currency then:
- A direct quote would be USD/AUD
- While an indirect quote would be AUD/USD.
For example, if the Australian Dollar is the domestic currency, an indirect quote would be 0.7800 AUD/USD which means that with 1 AUD, you can purchase 0.78 USD. The direct quote (USD/AUD) will be the inverse (1/0.7800) or 1.2820 USD/AUD which means that with 1 USD you can purchase 1.2820 AUD.
Forex Cross Currency
A Forex cross currency is a currency pair traded in Forex that doesn’t include the US Dollar in the quotation system. The most popular currency crosses include the following pairs: EUR/GBP, EUR/JPY, and GBP/JPY.
The cross currency pairs were released to help individuals who wanted to exchange their money directly without having to first convert it to USD. When trading these crosses take note that they are less liquid and more volatile, which means that you can also make more money trading these pairs.
Forex Bid and Ask
When you look at a currency quote you’ll often see two prices. The Forex market uses a two-price quotation system or two-way quote. A two-way quote system includes two prices, one for selling and the other one for buying.
On the left side, we locate the selling price or, in Forex terminology, the Bid price. On the right, we locate the buy price, or in Forex terminology, the Ask price.
The buy price quotes the numbers of units of the counter currency on the right that is equivalent to 1 unit of the base currency on the left. In this case, 1 Australian Dollar will buy 0.7787 US Dollars.
Typically your broker will give you Forex quotes in 4 decimals and 2 decimals for the Japanese Yen crosses; however you’ll notice that some brokers will add an additional smaller number at the end of a currency rate. This number represents fractional pips.
Fractional pips are a new pricing feature which gives you the chance to see more price detail and you’ll be able to see every small variation in price. With fractional pips, you have an extra digit and a quotation system composed of 5 and 3 decimals.
Forex Spread and Pip
The Forex price moves in very small increments which is the reason why currencies are quoted in pips – so you can monitor these small fluctuations. A pip is an acronym that stands for Price Interest Point and represents the smallest price change that a given currency can make.
Typically a pip is the last decimal of a quote or the fourth decimal of a price. If the AUD/USD exchange rate would move from the current price of 0.7786 to 0.7787, which represents a 1 pip increase in the AUD/USD exchange rate. For more on calculating profit and pips, read our article here.
Each increase or decrease in pips will automatically translate into a profit or a loss in your trade.
In Forex trading the difference between the bid price and ask price is known as the Spread. Usually, the spread is the fee you pay for doing business in the Forex market, and you’ll have to pay each time you open a trade.
By default, your Forex broker will automatically display the spread for each currency pair you trade so you’ll know every time how much you pay to get into a trade. In our case, the difference between the bid price (0.77856) and the ask price (0.77868) is 1.2. This represents the spread. The spread is a function of market liquidity and the supply and demand.