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Lesson 3 Currency Pairs: Learn How Currencies Function in Forex

Lesson 3 Currency Pairs: Learn How Currencies Function in Forex

Reading Time: 9 Minutes

Did you know the foreign exchange market (Forex or FX market) is the largest financial market in the world? It boasts an eye-watering daily turnover of more than US$6 trillion, with trading in the swap and spot markets responsible for the majority of market turnover.

With its enormous presence and global recognition, aspiring Forex traders are encouraged to explore the currency market’s structure. This includes understanding who the main players are, to how markets are analysed (trading strategies predominantly employ both technical analysis and fundamental analysis), and how currency prices are quoted.

Currency Pairs (Forex Pairs)

The Forex market operates through currency pairs that provide exchange rates. An exchange rate presents the value of one country’s currency against another country’s currency. This is the rate of exchange between these two currencies, hence currency pair.

In each currency pair, irrespective of the currencies involved, a base currency and a quote currency form the framework. The base currency is found on the left-hand side of the quotation (the first currency) and always denotes 1 unit of the base currency. The quote currency is on the right-hand side of the quotation (the second currency) and is regularly referred to as either a counter currency, a secondary currency or term currency .

Imagine EUR/USD trades at $1.2000, as illustrated in figure A (priced to the fourth decimal). The base currency in this case is 1 euro and the quote currency is $1.20. This means to purchase 1 euro it’ll cost 1.20 USD. An exchange rate informs how much USD per 1 euro. When entering long a currency pair, you effectively buy the base currency and sell the quote currency. Conversely, selling a currency pair involves selling the base currency and buying the quote.

Currency pairs can be quoted in either American o European terms. Currency pairs quoted in dollars per 1 unit of another currency are American (EUR/USD and AUD/USD, for example); those that quote in a currency aside from the dollar are European (USD/JPY or USD/CHF). European terms are not restricted to European-based currencies; any currency, aside from the USD, can form a European term currency pair. Currency pairs that do not include the US dollar, however, are referred to as cross currency pairs, or crosses.

Currency Pair Groups

Trading Forex (or currency trading) successfully requires an understanding of how currency pairs are organised:

• Majors

Major currency pairs contain the most heavily traded currencies—think EUR/USD, GBP/USD, USD/JPY, AUD/USD and NZD/USD. The majors always contain the US dollar.

• Minors

Minor currency pairs, sometimes referred to as cross-currency pairs, are those not involved with the US dollar. Popular minors are GBP/JPY, EUR/GBP, AUD/JPY and EUR/AUD.

• Exotics

Exotic currency pairs include a major currency that’s paired alongside less traded currencies and can be relatively thin markets (low liquidity/trading volume). Exotic currencies are those typically associated with developing or emerging countries. Common exotics are the Japanese yen against the Norwegian krone (JPY/NOK), and the New Zealand dollar against the Singaporean dollar (NZD/SGD).

• Direct Vs. Indirect

Two important terms to be mindful of are direct and indirect quotations. Direct quotation provides the value of 1 unit of foreign currency in equivalent units of local (home) currency. For US citizens, therefore, EUR/USD is a direct quotation. An indirect quotation is the inverse of a direct quotation. The value of 1 unit of local currency is provided in terms of an equivalent value of foreign currency. For the same US citizen, the USD/EUR is an indirect quotation.

Which Pairs Should You Trade?

The most commonly traded currency pairs house major currencies: the US dollar, the euro, the British pound, the Japanese yen, Swiss franc, Australian dollar and Canadian dollar, for example. The US dollar, according to the Bank for International Settlements, remains the dominant currency, on one side of 88 percent of all trades. The euro, in comparison, was on one side of 32 percent of all trades.

Aside from trading experience and the trading style, volatility (daily price movements between the high and low) as well as liquidity (how easy it is to transact within a market without causing too much price fluctuation) and trading volume can be deciding factors for which currency pair to trade. A currency pair tends to work with increased liquidity when its respective financial centre is active. For that reason, time of day is important. While Forex trading is accessible 24 hours a day, five days a week, it is composed of trading sessions, each of which bring with it different conditions: Sydney, Tokyo, London (Europe) and New York.

AUD/USD and AUD/JPY offer healthy trading ranges during the Asian session. Tokyo cash trading (stock market) gets underway at 9:00am local time (00:00am GMT). Another example are GBP-based currency pairs which are usually more active throughout the London session, between 8am and 4:30pm local time. It is also important to take note of trading session overlaps. The London and New York session overlap is a busy time in financial markets and can generate notable volatility. According to UK and US stock markets, overlap times (GMT) are currently between 2:30pm (US cash open) and 4:30pm (UK cash close). However, it is important to remain aware that volatility can fluctuate depending on market conditions.

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