Concept #2: Currency Pairs

When you buy stocks on the Stock Exchange, you have the option of buying the stock of a single company at a time, or multiple companies at a time. You may also choose to sell your stock back right away, or hold it for an indefinite period of time.

The value of stock from a company like Microsoft, for example, is determined largely by that company’s performance (profits, meeting quarterly goals, etc), and not directly affected by the performance of other corporations.

The foreign exchange market works a little bit differently.

The value of any currency on Forex is determined in relation to the value of all other currencies. In other words, the value of 1 U.S. dollar changes based on whether you are comparing it to the Euro, the Australian dollar, the Japanese Yen and so on.

The buying and selling of any of these currencies is always done in what’s known as currency pairs.

A currency pair consists of a base currency and a quote currency. The base currency is the currency you intended to purchase. The quote currency is the currency you intend to use to purchase the base currency.

Together, the pair shows you how much of the quote currency is needed to buy one ‘unit’ of the base currency.

To illustrate this, let’s look at some exchange rates for December 15th, 2007. We’ll compare the U.S. Dollar against the Euro, Canadian Dollar and Japanese Yen:

1 EUR = 1.44245 USD /1 USD = 0.693265 EUR

1 CAD = 0.9830391 USD / 1 USD = 1.01720 CAD

1 JPY = 0.00882807 USD / 1 USD = 113.275 JPY

The pairs are as follows:

EUR/USD = 1.4 - selling Euros to buy Dollars
USD/EUR = 0.69 - selling Dollars to buy Euros

CAD/USD = 0.98 - selling Canada Dollars to buy U.S. Dollars
USD/CAD = 1.01 - selling U.S. Dollars to buy Canada Dollars

JPY/USD = 0.0088 - selling Yen to buy Dollars
USD/JPY = 113.27 - selling Dollars to buy Yen

Notice that the currency being sold is listed first. The EUR/USD pair tells you that for every Euro you sell, you are purchasing 1.4 U.S. Dollars. Likewise, the USD/EUR pair tells you that for every Dollar you sell, you are purchasing 0.69 Euro.

You are always buying and selling simultaneously when you trade currency on Forex.

Now, let’s say that you wanted to turn a profit in U.S. Dollars by trading in these currencies?

In an ideal scenario, you would already be holding Euros in your online trading account, and you would have purchased these Euros on a day when the dollar was stronger.

For example, let’s say you bought 1,000 Euro when the exchange rate was USD/EUR = 1.40.

This means that every $1 you spent purchased 1.4 Euros. In order to buy 1,000 Euros at that rate, you had to spend 1000 X 1.40 = $1,400 U.S. Dollars.

Make sense?

Now, let’s say you held onto those Euros until the exchange rate went up to USD/EUR = 1.44. You wouldn’t want to buy the EUR/USD pair (selling your Euros to buy Dollars) because you would lose money, right?

Instead, you look for something like the Japanese Yen, which is valued far below the Dollar, and then you think: “If the Euro is worth more than $1, then I can buy more Yen with Euros than I can with Dollars. Then, I can take advantage of the Dollar’s strength against the Yen.”

So, you buy the Yen with the Euro and then sell the Yen back to buy Dollars.

Let’s do the math:

EUR/JPY = 163.3

1,000 EUR X 163.3 = 163,300 JPY

JPY/USD = .0088

163,300 JPY X .0088 = $1,437.04 USD

$1,437.45 - $1,400 = $37.45 Total Profit

I want you to be able to follow this, so let’s recap what happened…

First, you traded the EUR/USD pair at a time when $1,400 U.S. Dollars could buy you 1,000 Euro. You held it and waited for both the Dollar and the Euro to rise against the Yen.

Then, you traded the EUR/JPY pair, effectively buying more Yen with Euros than you could with Dollars.

Finally, you traded the JPY/USD pair, and gained enough margin (via the purchasing power of the Euro) to gain a $37.45 increase on your original investment of $1,400 USD.

You effectively leveraged a series of currency pairs in order to profit. This is what I meant when I told you that Forex trading is never as simple as a one-to-one transaction!

There’s one thing slightly off with the example I gave you above, though. You’ll notice that I shortened the quotes by a few decimals places? I did so for the sake of making the math easier to follow.

However, when trading any currency pair, you must remain mindful of the full exchange rate, all the way down to the last decimal.

Remember when I said that most profits on Forex are made by trading on volume, and at very slim margins?

Even the slightest change in one of those numbers can have an impact.

This brings us to our next fundamental concept: The ‘Pip’.