Currency Pairs – A Guide to Understanding and Trading
Table of Contents
- Currency Pairs – A Guide to Understanding and Trading
- Base Currency And Quote Currency
- Bid And Ask Prices
- Major Pairs
- Minor Pairs (A Slight Distinction)
- Cross-Currency Pairs
- Exotic Currency Pairs
- What Is The Reason For The Trading The Exotics?
- African Currencies:
- Eastern European Currencies:
- Far And Near Eastern Currencies:
- Latin American Currencies:
- Middle Eastern Currencies:
- Drawbacks To Trading The Exotics:
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Forex is always traded in pairs.
Whenever you see a currency exchange rate, it will belong to a currency pair such as EUR/USD. EUR/USD indicates two currencies: the Euro and US Dollar.
Here is a screenshot of currency pairs displayed in the market watch window of Metatrader:
Base Currency And Quote Currency
The first currency of a currency pair is referred to as the “base currency”, while the second one is called the “quote currency”, and they are often separated by a forward slash (“/”).
The dominant base currencies are:
|Base Currency||Currency Pairs|
|EUR||EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD|
|GBP||GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD|
|USD||USD/CAD, USD/JPY, USD/CHF|
The base currency value is always 1, for example, 1 Dollar, 1 Pound, 1 Euro, etc.
The calculation is: 1 unit of Base Currency buys X units of the Quote Currency.
If the base currency is USD, such as USD/JPY, a quote of USD/JPY 88.48 means that one U.S. dollar is equal to 88.48 Japanese yen. If the base currency is EUR, such as EUR/USD, then a quote of 1.3980 means that one Euro is equal to 1.3980 US Dollars.
A trader buys a currency pair if he believes the base currency will rise relative to the quote currency, or sells a currency pair if he believes the base currency will decrease relative to the quote currency.
For example, let us look at EUR/USD, where Euro is the base currency and thus the “basis” for the buy/sell. If you believe that the Eurozone’s sovereign debt crisis will ultimately defeat the euro, you would execute a sell EUR/USD. You have sold euros with the expectation that they will fall in value against the US dollar.
Note: Forex trading involves the simultaneous buying of one currency and selling of another within the pair. Therefore, when you buy a currency pair, you buy the base currency and sell the quote currency.
Bid And Ask Prices
The currency pairs are usually traded and quoted with a “bid” and “ask” price.
The “bid” is the price at which you can sell base currency / buy quote currency. The “ask” is the price at which you can buy the base currency / sell quote currency. You will see that the ask price is always higher than the bid price.
Spread is the difference between the bid and the ask price (Spread = Ask-Bid).
The key to successful trading lies in selecting one or two pairs of currencies that you wish to trade as a beginner. As you gain confidence, you may wish to add more pairs in your trading portfolio. But for a new trader or investor it is always advised to trade with a limited number of pairs just to ensure simplicity.
The eight most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, NZD and AUD) are called the major currencies, and all other currencies are referred to as minor because they play less of a role and are less liquid.
The Major Pairs are simply the seven major currencies paired with USD. They account for more than 70% of all Forex trades:
Bear in mind that economically strong and politically stable currencies are in higher demand than currencies based in less stable areas.
Why Are These The Seven Major Pairs?
It all has to do with volume. These are the most actively moved (traded) currencies in the world. Their paring is significant and the trading volumes total to the trillions of dollars every day. These are generally the most suitable pairs for trading, especially for beginner traders. There are several reasons, starting with the lower spreads that are available on these pairs. The more liquid a currency pair is, the lower the spread typically is.
What is the spread? The spread basically is the difference of the ‘bid’ and the ‘ask’ price, or in other words, this is how brokerages earn their commissions. A typical spread on a major pair is between one pip and three pips (though sometimes upwards of four pips). This is at the discretion of the broker primarily, but relates also very closely with the liquidity of the pair, as mentioned.
What Is The Importance Of These Seven Major Pairs?
These seven major pairs should always be the starting point for the novice trader just learning a good Forex trading system. These pairs will give the largest number of opportunities (trade setups) for trade placements and are ideal for Forex day trading. Most Forex trading systems will recommend to their students that they trade these pairs, and for good reason. There are more than enough opportunities in these seven major pairs to provide for a full-time trader.
Another important thing that you need to keep in mind is that the above seven major pairs tend to respond to technical analysis very well. This might be due to the high liquidity of these pairs which makes them more market efficient and price discovery more ideal.
If you just master three to four of the major currency pairs, you could be making a lot of money. Most of the action in the forex market belongs to these major pairs, as 90% of the currency transactions involve them. So it is best to stay with the majors.
Minor Pairs (A Slight Distinction)
Some writers on currency pairs have grouped only the first four currency pairs as majors (EUR/USD, USD/JPY, GBP/USD, USD/CHF); relegating the last three to the distinction of being a minor pair (USD/CAD, AUD/USD, NZD/USD) due to the significantly less trading volume.
These last three currency pairs have also won the distinction of being called commodity pairs because their economies revolve around exporting commodity-based resources.
|The Commodity Currencies|
|AUD/USD: Aussie (Australian) Dollar|
|USD/CAD: Dollar Canada or Loonie|
|NZD/USD: Kiwi (New Zealand) Dollar|
The other pairs that won the place of being called minor pairs are the Scandinavian currencies (USD/NOK, USD/DKK, USD/SEK).
|The Scandinavian Currencies|
|USD/NOK: Norwegian Krone (Norway)|
|USD/DKK Danish Krone (Denmark)|
|USD/SEK Swedish Krona (Sweden)|
A cross-currency pair, or cross or crosses for short, is any currency pair that does not include the U.S. Dollar.
What is the reason for the trading the crosses?
The vast majority of currency trading takes place in the dollar pairs, so the crosses become a nice alternative to always trading in the U.S. Dollar.
Reason#2: Currency Targeting
The crosses enable traders to more directly target trades of specific individual currencies to take advantage of news or events. For example, your research may suggest that the Euro has massive problems due to sovereign debt issues (Greece, Ireland and Portugal) and that it is destined to become weaker. You may look around to take advantage of this and might initially consider selling the EUR/USD, but then you conclude that the US Dollar is not much better off, since the United States has its own massive debt issues. Your further research shows that Switzerland has a much stronger economy and less debt, and so you decide to take advantage of this by shorting EUR/CHF.
* These “Typical Spreads” are those of FXCM, taken from http://www.fxcm.com/forex-spreads.jsp, and were derived from the weighted average spread for the period of June 1, 2011 to June 30, 2011. Each broker’s typical spread varies and may not as accurate as plotting the average spread using a good spread indicator (such as StatMonitor_1.1Phat- or FXRM Spread History) plotted on currency charts.
Drawbacks To Trading The Crosses:
Drawback#1: High Spread
Some of the crosses above have a high spread. For instance, EURNZD has a typical spread of 7.5 pips. Compare that high spread with the low spread we have seen with the majors. Pairs like this have a higher spread due to its lower liquidity (fewer traders trading it).
Drawback#2: Less Technical
Because the crosses are not traded as heavily as the majors, they do not respond to technical analysis as well. The exceptions to this rule are EUR/JPY and GBP/JPY, but even they are more volatile and erratic than EUR/USD and GBP/USD.
Exotic Currency Pairs
Virtually all of the so-called exotic currencies that usually come from developing countries are quoted as the counter-currency against the USD like this: USD/XXX where XXX is the ISO 4217 code for the exotic currency (e.g., USD/MXN). A partial list of the ISO codes and names of the most common exotic currencies follows in alphabetical order and categorized by geographical location.
Note: Even if the exotic currency is not quoted as the counter-currency against the USD, it is still often listed second after the major currency (e.g., EUR/MXN), though there are always exceptions (e.g., CZK/JPY).
What Is The Reason For The Trading The Exotics?
Some traders are lured into the exotics because of their foreign sex appeal. You might consider yourself a “worldly” person and should trade an international market. As such you might look for a broker that offered over 100 currency pairs thinking you might need that. This is the shallowest of reasons and if you don’t know what you are doing you will be left heartbroken.
Reason#2: Country Specific Economics
The exotics enable traders to take advantage of the economic situation of a country. For instance, you might have already realized that most G7 countries are loaded with economic problems and debt, and you want to diversify into the currencies of countries that are most fiscally sound (e.g., long the Chilean Peso by selling USD/CLP, and long the Singapore Dollar by selling USD/SGD). Or, you might be the one who wants to short the currencies of countries you know are in deep trouble. Currently, you might be watching the tensions in the Arab world, and wanting to short the Egyptian Pound (EGP/USD) or the Libyan Dinar.
Most firms trading these currencies are doing so because they have to. Imagine being a Hungarian construction firm needing to buy machinery from Japan (HUF/JPY).
|XAF||Central African Franc||http://en.wikipedia.org/wiki/Central_African_CFA_franc|
|XOF||West African Franc||http://en.wikipedia.org/wiki/West_African_CFA_franc|
|ZAR||South African Rand||http://en.wikipedia.org/wiki/South_African_rand|
Eastern European Currencies:
Far And Near Eastern Currencies:
|CNY||Chinese New Yuan
|Perhaps one of the strongest currency
pairs; however, not offered by most brokers.
|HKD||Hong Kong Dollar||http://en.wikipedia.org/wiki/Hong_Kong_dollar|
|TWD||New Taiwanese Dollar||http://en.wikipedia.org/wiki/New_Taiwan_dollar|
Latin American Currencies:
|CRC||Costa Rican Colon||http://en.wikipedia.org/wiki/Costa_Rican_Colon|
Middle Eastern Currencies:
|AED||United Arab Emirates
|ILS||Israeli New Shekel||http://en.wikipedia.org/wiki/Israeli_new_
|SAR||Saudi Arabian Riyal||http://en.wikipedia.org/wiki/Saudi_riyal|
Drawbacks To Trading The Exotics:
Drawback#1: High Spread
Most of the exotic currency pairs have a very high spread. While you will be paying about 2 pips for a pair like EUR/USD, you might find yourself paying a spread of 200 pips in exotic pairs that are less liquid like the USD/MXN, CZK/JPY and AUD/MXN. Granted, each pip might calculate to only 1/10 of everything else; yet even at 1/10, the pip spread is still high. When you are down 200 pips from the get go it makes placing a profitable trade a real challenge.
Drawback#2: Erratic Trading
When currencies are not traded heavily, they tend to move erratically. A low liquidity often means that, besides having a more expensive spread, the currency pair does not respond to technical analysis very well. Thus, due to their high spread transaction cost and corresponding lack of technical discoverability, most exotic currency pairs are not profitable to trade.