The foreign exchange market, also called the currency or forex (FX) market, is the world’s largest ﬁnancial market. It’s the most traded market in the world, with over $5 trillion worth of currencies traded globally every day.
Forex is always traded in pairs. This is because the forex trader is simultaneously buying one currency and selling another. The currency pair itself can be thought of as a single unit, an instrument that is either bought or sold. Examples are the euro and US dollar (EUR/USD), or the British pound and Japanese yen (GBP/JPY).
The ﬁrst currency in an FX pair is known as the base. The base currency is the one that a trader thinks will go up or down against the second currency in the pair. This second currency is known as the quote or counter currency.
The euro against the US dollar is a widely traded pair. An example of a currency price is EUR/USD = 1.3560/1.35602 (sell rate/buy rate). In this instance, the euro is the base currency and the US dollar is the quote currency. To buy one unit of the base currency, the trader will have to pay 1.3562 in the quote currency - US dollars in this case. Conversely, if the trader wishes to sell one euro, they would receive 1.3560 US dollars.
A trader buys the EUR/USD pair if they believe the euro will increase in value relative to the dollar. Buying the EUR/USD dollar pair can also be referred to as ‘going long’. A trader would sell the EUR/USD pair - also known as ‘going short’ - if they believe the value of the euro will go down relative to the dollar.
There are many currency pairs for traders to choose from when placing a trade in the forex market. Major currency pairs are any pair that include the US dollar (USD). Major pairs are the most widely traded currencies in the foreign exchange market.
Four of the major currency pairs in forex trading are:
The major pairs make up 75% of all forex trades. The majors are the most liquid and widely traded in the forex market. They make up the vast majority of all FX trades. Because these pairs have the largest volume of buyers and sellers, they also typically have the tightest bid (buy) and ask (sell) spreads. The spread is the difference between the buy and the sell price.
Exchange rates ﬂuctuate based on which currency is stronger at certain times. Traders seek out the best foreign exchange rate. These rates are supplied by global banks, and updated in time periods of less than a second. The forex market is a fast-paced one.
Commodity currencies are those from countries that have large quantities of commodities or other natural resources. The exchange rate of the currencies of these countries are tied to their respective export activities. This is because the strength of the economy can be highly dependent on the prices of their natural resources. Examples of these countries include Russia, Saudi Arabia and Nigeria.
A currency pair’s correlation refers to the similarities shared by various pairings. In the forex market, no single currency pair is traded completely independent of the others. An understanding of these correlations is helpful when managing a portfolio. For example, when trading the euro against the Japanese yen (EUR/JPY pair), a trader is effectively trading a derivative of the euro dollar (EUR/USD) and dollar yen (USD/JPY) pairs. Therefore the EUR/JPY pair must be somehow correlated to one or both of these other currency pairs.
It’s useful to get a better understanding of currency correlations and gain an insight into the relationship between currency pairs. Considering whether they are negatively or positively correlated, or if they are likely to move in the same direction, opposite directions, or completely randomly could be useful.
Forex trading offers frequent trading opportunities, as currency prices are constantly ﬂuctuating in value against each other. FX trading allows traders to speculate on all the major currency pairs. The only limit to which currency pairs can be traded are the pairs and quantity offered by the trading platform individual traders choose.
The three main types of currency pairs are majors, minors (crosses) and exotics. The major currency pairs are the most popular to trade, as they are the most liquid. That is to say these pairs have the highest trading volume. Minor currency pairs are ones which leave out the United States dollar, and they are normally less liquid. Examples include the euro and Swiss franc (EUR/CHF), Canadian dollar and Japanese yen (CAD/JPY), or pound sterling and Australian dollar (GBP/AUD). Cross pairs can provide trading opportunities when the majors are presenting less favourable conditions.
There are also exotic currency pairs. These are the least traded in the forex market, and are less liquid than the cross pairs. Prices can ﬂuctuate greatly, and due to the lower volume of trades, spreads can be wide. There also tends to be less historical data on these pairs, so those relying on technical analysis may ﬁnd information harder to come by.
Currency pairs are categorised according to the amount of volume that is traded on a daily basis for a pair. All the major currency pairs have very liquid markets that trade 24 hours a day, every business day.
Because the major currency pairs are the most liquid and widely traded in the world they will likely have tighter spreads. These tighter spreads reduce one’s dealing costs, and therefore increase the margin for profit.
A hard currency is one which is less likely to depreciate suddenly, or ﬂuctuate much in value. It’s a stable currency which is widely accepted, and typically highly liquid in the forex market. Examples are the US dollar, euro and Japanese yen.
Interest rates around the world are set by each country’s central bank. The rates reﬂect the health of individual economies. Central banks tend to raise rates when the economy is growing, and cut them to stimulate a struggling economy. These interest rates govern the forex market. This is because a currency’s interest rate is such a big factor in determining its perceived value.
Forex trading is the exchange of one currency for another at an agreed price. The foreign exchange market differs from other ﬁnancial markets in that it has no physical location or central exchange. The whole market runs electronically, through a network of banks. It also runs continuously for 24 hours a day, five days a week. The forex market is the most popular ﬁnancial market, traded by individual retail traders, banks and businesses alike.
Market liquidity - the amount of buying and selling volume happening at any given time - is extremely high in the forex market. This is due to the market’s huge scale. A pip, which stands for price interest point, is a tool of measurement related to the smallest price movement made by any exchange rate.
A pip is typically the fourth digit after the decimal point of the currency pair. So if the euro/dollar pair (EUR/ USD) were to move from 1.0630 to 1.0631, that’s a one pip movement. The pip value in forex major pairs determines the amount of profit or loss that a trader will make per trade.
Long and short positions are the basis of buying and selling currency pairs. For example, when trading the euro dollar (EUR/USD), if a trader thinks the euro will strengthen against the US dollar, they would place a buy trade. This is known as going long. For every point or pip the euro rises against the dollar, they would make a proﬁt. If the price of the euro rises against the US dollar, the trader would make a loss for every pip it falls.
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CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.
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