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Now, “bid” is the selling price. This is what you sell the asset at. The higher of the two is the “ask price” or buy price; the rate at which you buy the asset. The difference between these two prices is the “spread.” This is your cost of trading. Depending on how liquid your asset is and your choice of broker, the spread can be tight or wide. For instance, a broker can source quotes from a large pool of liquidity providers to offer you the tightest bid/ask spreads.
Now, in the next hour, if the price moves to 0.6880/0.6882, you have a winning trade. You could close your position by selling at the current price of USD 0.6880.
In this case, the price moved in your favour. But, had the price declined instead, moving against your prediction, you could have made a loss. If that loss resulted in your account equity falling below your margin requirements, your broker may issue a margin call.
Notice how a small difference in price can offer opportunities to trade? This small difference is known as “pip” or “percentage in point.” In the forex market, like in the above example, it is used to denote the smallest price increment in the price of a currency. For assets like the AUD/USD, which include the US Dollar, a pip is represented up to the 4th decimal place. But, in case of pairs that include the Japanese Yen, like the AUD/JPY, the quote is usually up to 3 decimal places.
This continuous evaluation of price movements and resultant profit/loss happens daily. Accordingly, it leads to a net return (positive/negative) on your initial margin. In case your initial margin is lower, the broker will issue a margin call. If you fail to deposit the money, the contract will be closed at the current market price. This process is known as “marking to market.”
|If the price
|To||You Could Gain or Lose
(for a long position)
|Resulting in a Return
of the Initial Margin
|Rises by 10%||0.75603/0.75606||0.75603/0.75606||1000%|
|Rises by 5%||0.72167/ 0.72169||USD 687.4||500%|
|Declines by 10%||0.61857/0.61859||USD -1374.6||-500%|
|Declines by 5%||0.65293/0.65297||USD -687.4||-1000%|
Currencies are traded in pairs, like the Euro/US Dollar (EUR/USD) or Australian Dollar/US Dollar (AUD/USD). Currencies are denoted in 3-lettered ISO codes, such as EUR (Euro), GBP (Great British Pound) and USD (US Dollar). When you see a currency quote, the first currency is called the base currency and the second currency is the quote currency or counter currency. For instance, say the EUR/USD is trading at 1.1086. This means to buy 1 unit of Euro, you will need $1.1086. USD
The higher price $1.1087 is the ask rate, while $1.1086 is the bid rate. The bid price is the maximum price a buyer is willing to pay for the currency. Ask price is the minimum price a seller is willing to accept for the same currency. These rates fluctuate constantly, depending on supply and demand, market sentiment and external events.
The difference between these two rates is known as the spread. This includes the broker’s charges. The spread depends on your choice of currency pair and the forex broker. Licensed forex brokers who provide ECN (Electronic Communications Network) pricing can source price quotes from multiple liquidity providers in the market. This means they can offer the tightest spreads.
Majors, Minors and
Not all currency pairs are traded in large volumes. The US Dollar, being the world’s reserve currency, is definitely traded the most; although, over the years, its dominance has waned somewhat. Based on how frequently they are traded, currency pairs are segregated into major, minor and exotic categories.
Exotics can include a major currency with an emerging market currency. Trading in exotics is considered risky, since they tend to have low liquidity, wider spreads and political instabilities in these countries can make these currencies volatile.
Some examples are:
US Dollar/Hong Kong Dollar
Australian Dollar/Mexican Peso
In the brackets are the common nicknames for these currency pairs.
Going Long or Going
When you assume a long position in a currency pair, you buy a currency in the hopes that its price will rise (appreciate) in the future. This means you wish to buy the base currency and sell the quote currency, since you expect the base currency to appreciate with respect to the quote currency.
When you assume a short position in a currency pair, you sell the base currency, expecting it to depreciate (decline in price) in the future, allowing you to buy it at a later date but at a lower price.
When you decide on your position size, a term you will hear is “lot.” Lots are standardised position sizes for currencies. The forex market gives you the flexibility to trade according to your means and risk profile. The standard size for a lot is 100,000 units of the base currency. There also are mini, micro and nano lot sizes that contain 10,000, 1,000 and 100 units of the base currency, respectively.
What is Liquidity in Forex Trading?
Liquidity in the forex market refers to the ability of a currency to be bought or sold on demand. When you trade in major currency pairs, there are a lot of buyers and sellers in the market. This means that there is always likely to be an opposite player for every position you take. You can buy or sell large amounts of these currencies without causing any significant difference to the exchange rate.
Liquidity fluctuates during trading sessions. You are likely to see significant activity during the overlapping of the New York and London sessions. Depending on your style of trading, you could benefit from choosing specific trading sessions. For instance, short term traders prefer the US or London sessions, when large price breakouts and percentile movements tend to occur. The Tokyo session is often range-bound, which might not be the best for them.
Liquid markets, such as forex, tend to fluctuate by smaller increments, since high liquidity means less volatility. However, high volatility can occur due to significant external events.
The Concept of
Leverage in Forex
Leverage in forex trading is a useful financial tool. It allows traders to gain greater exposure to market movements than they could otherwise afford. So, this means a trader can enter a position worth $100,000 with just $1,000 in their account, with a 100:1 leverage ratio.
The leverage amount is provided by the forex broker. Consider it as a loan, which can help you to increase your gains with little price increments. However, also remember that leverage magnifies your losses too, if prices move in the wrong direction. This is why, it is important to put in place robust risk management strategies while trading.
When you decide to trade, you need to open a margin account with a regulated broker. Here, you will need to deposit an initial margin amount that is required to keep your leveraged positions running.
This is also called deposit margin. When the amount drops below the minimum level, your broker will issue a margin call. This means that you need to deposit funds to keep your positions open. Otherwise, the broker may close your positions.
A 50:1 leverage ratio means a minimum margin requirement of 1/50 or 2% of the total trade value from you. Similarly, a 100:1 leverage ratio means that you need to deposit at least 1% of the total value of your trade in your margin account.
Technical analysis is based on the principle that the markets tend to repeat their historical price trends. To discover these trends, traders rely on technical indicators and forex chart analysis. Technical indicators are actually statistical formulae that can provide important information about the market. They are categorised into:
Trend: Such as Simple Average, Trend lines, Moving Average Convergence Divergence (MACD)
Volume: Such as On Balance Volume (OBV), Chaikin Money Flow
Momentum: Such as Stochastic Oscillators, Relative Strength Index (RSI)
Volatility: Such as Average True Range (ATR), Volatility Index (VIX)
Forex trading platforms like MetaTrader 4 and MetaTrader 5 come with pre-installed technical indicators, allowing you to analyse the ongoing trends and any chances of price reversals. Based on these indicators, you can create forex trading strategies.
These platforms also allow you to use a combination of both fundamental and technical analysis. While fundamental analysis, through financial news alerts, allows traders to gauge the interest rate and inflation outlook for both currencies in a pair, technical indicators and charts provide insight into trends and ranges within the price history. Chart patterns can provide clues regarding how prices might move within the patterns and where they are likely to go after a break-out.