One of the most difficult things for newcomers to the forex to wrap their heads around is how to read currency-pair quotes. After all, most of us are used to seeing one price for items-a loaf of bread costs $1.89; a stock sells for $39.50 per share, etc. But in these cases, we are exchanging one currency-U.S. dollars-for physical goods. Buying one currency with another one can be a real headscratcher, but this article will hopefully allay some of your confusion.
How Currencies Are Traded
Currencies are traded in currency pairs. For example, a common currency pair is the U.S. dollar (USD) and the Japanese yen (JPY), expressed as USD/JPY. A quote for this currency pair might look like this: USD/JPY 116.01/05. This indicates a 116.01 bid price (the first number) and a 116.05 ask price (replace the final two digits of the first number with the number appearing after the slash).
The bid price tells you how many units of the counter currency (the currency listed after the slash) you can obtain for one unit of the base currency (the currency listed first). In this example, you could obtain 116.01 Japanese yen for one U.S. dollar. The ask price tells you how many units of the counter currency you need to obtain one unit of the base currency. In this case, the market maker is willing to sell you one U.S. dollar for 116.05 Japanese yen.
If you've been paying attention, you've undoubtedly noticed that the market maker is buying dollars for 116.01 yen, and selling them for 116.05. This "profit" (the difference between the bid and the ask) is called the spread, and is measured in pips. One pip is equal to each decimal-point difference between the bid and ask, so in this case, the spread is four pips.
For another example, let's look at the Euro-U.S. dollar (EUR/USD) currency pair. First, notice that the Euro is listed first. This means that it, not the U.S. dollar, is the base currency. Typically, the U.S. dollar is the base currency, but not when compared to the "Queen's currencies" of the Great Britain pound (GBP), the Australian dollar (AUD), or the New Zealand dollar (NZD), nor when compared to the Euro (EUR).
Common Currency Pairs
There are four "major" currency pairs: EUR/USD, USD/JPY, GBP/USD, and USD/CHF (GCHF = Swiss franc); and three "commodity" pairs: USD/CAD, AUD/USD, and NZD/USD (CAD = Canadian dollar). That's a total of eight currencies, which are a lot easier to follow than the more than 13,000 stocks that are actively traded in the U.S. stock market.
You might have also noticed that the currency pairs above all involve in the U.S. dollar. Any currency pair that does not use the USD as either the base currency or the counter currency is considered a cross currency. An example might be EUR/JPY or GBP/CHF. It's important to note that not all forex brokers deal in all currency pairs, so if you have particular strategies in mind, it's important to make sure your broker deals in the pairs you want to be able to trade.