If you are not working with a large bank, investment firm, or government agency, then your participation in the online foreign exchange market will be at the retail level. As a retail forex trader, you will work with a forex broker or market maker and you will likely be given the opportunity to trade with a much larger amount of money than the actual trading capital in your account. This is called trading on leverage, and with a typical leverage ratio of 100:1 this means that with $1,000 worth of trading capital you can control a trading position of $100,000.
Most of the people in the world do not speculate in the foreign exchange market, and the extent of their foreign exchange transactions occur when they travel to a foreign country or perhaps purchase international real estate. When you are dealing with foreign exchange on this level then you are likely going to be concerned with the exchange rate up to the cents position, or second decimal place. However when you look at most forex trading software platforms you will see the exchange rates quoted to the hundredth of a penny position, or the fourth decimal place. A fluctuation of this amount is called a pip, so a change of 100 pips would mean one penny as far as the foreign traveller is concerned.
A difference of under a penny might not matter to the foreign traveller, but when you are trading hundreds of thousands or millions of dollars then these small changes will really add up. A standard lot on a typical retail forex trading platform will be $100,000, and with a trade of this size a single pip fluctuation would be worth $10. This means that if you could capture 100 pips of price movement on an open position, or 1 penny worth of difference in the exchange rate, then you would have earned $1,000 on your open trade or doubled the size of the trading capital for that specific trade. From these numbers you can see that trading with leverage makes a very big difference to your bottom line profits, and can allow you to increase or decrease your account balance rapidly.
Many forex brokers promote the fact that they offer commission free trading, but this does not mean that it is actually completely free to place trades. The broker still earns a commission when you trade, but instead of a direct commission they will create a difference between the price that you can buy a currency at and the price that they will sell it to you at. This price difference is called the spread, and you will find that more popular currency pairs have smaller price spreads than the more exotic and less traded currency pairs.
