How To Understand Currency Pairs
This video deals with the foundational element of Forex trading - the currency pair. As we have covered in previous videos, all currencies are priced with relation to another currency.
Understanding the conventions behind how that pair is written, how it is referred to and how the price is presented is an essential basic skill, that you have to learn now to progress.
Currencies
All currencies are written as a pair, usually with an accepted three letter acronym that refers to a specific currency a dividing slash and then the next three letter acronym.
In this example we have EUR which is EURO and USD which is US Dollar. These two are obvious, and most are unforgettable once you know, but some can be a little less clear to an English speaker - CHF, is the Swiss Franc, for instance - nothing to do with China!
You can write currency pairs without the slash, so just EURUSD and in Forex circles most people will understand what you are getting at.
When you write the price of a currency pair you have a base currency - which is the first of the pair, in this case the Euro, and the quote currency, the second in the pair, in this case the US Dollar.
The base currency is the currency that is being priced. The number of the price is how much of the quote currency 1 of the base currency would cost to buy or could be sold for.
In a simple example, if USD was half as valuable as the EURO, the price of EUR/USD would be 2.0000 That is because you would need to sell two dollars to buy 1 Euro and 1 Euro would buy you two dollars.
The base currency is always 1, the price of the pair is the amount of the quote currency that would buy you one of the base currency.
This idea seems a bit odd but you’ll understand it very quickly once you have seen a few examples.
The next thing to understand is that currency pairs always have TWO prices. One of the bid price and one is the ask price.
The bid price is the price that the other person in the trade is bidding to you - so that is the price at which you can sell them that pair.
The Ask price is what they are asking, so it is the price at which you can buy. The ask price is also sometimes called the Offer price as that is the price that they are offering the pair for, so the price at which you can buy.
Retail trading brokers are increasingly simplifying this and simply referring to them as the sell and buy prices.
You will have noticed that there is a price difference between the bid and ask price. That is because the broker you are trading with makes a profit by buying and selling the currency pair at a slightly different price.
This price difference is known as the spread. It is a cost of doing business in trading and is how your broker is paid for the service they provide.
In this example, the spread is a difference of one between the final digits.
This is known as 1 pip.
Now! Pips! The little numbers by which your success as a trader can be measured! Tho, some people do prefer cold hard cash!
Let’s jump into explaining exactly what a pip is
Pips Explained
As you may have begun to work out, there are established conventions all almost all areas of Forex trading.
Not the least of these is how you calculate pips.
Pips are essential to pricing currency pairs and working out how much or little a price has gone up or down.
Most currency pairs are quoted to the fourth decimal place. The fourth decimal digit is known as the Pip. Some currency pairs, notably those including the Japanese Yen, are quoted to two decimal places, with the second decimal being the Pip.
With electronic trading, however, many brokers have introduced a fifth digit for traditional four decimal pairs, and a third digit for traditionally two decimal pairs.
This last digit is, as you would expect, a fraction of a pip. That is sometimes known as a pipette!
Often brokers will highlight the number that is a full pip, or maybe make the pipette number smaller to try and make it clearer what counts as a pip.
If you are trading something unusual it may be hard to work out which number is a pip and which is a pipette, but the common currency pairs usually have obvious conventions that are adhered to.
Even the phrase ‘common currency pairs’ actually has a convention that I could have used! The most commonly traded currency pairs are actually called The Majors. The less frequently traded pairs are called hte Minors and the most unusual pairs are called Exotic.
Majors Explained
When we are talking about majors, it is important to note that we are talking about the pair.
So for instance, GBP isn’t a major, but GBPUSD is a major, and USDJPY is a major. That is because, as we have said currencies are always traded in pairs, and it is the frequency with which the pairs are traded that make them a major.
There is another convention here that you have to be aware of.
When quoting currencies there is a correct order in which to do it. It is often said that USD is normally quoted first. But that can be confusing when it is not in the case of most of the majors - EURUSD, GBPUSD, AUDUSD, NZDUSD! But, other than these it is usually quoted first.
There is no real reason for this except historical quirks.
What classes as a major is a convention, not a law, but these 7 are usually accepted as the major currency pairs
The nicknames on the right, well some are more common than others! You won’t go wrong referring to cable, but if you mention the Gopher some people may look at you funny. I suggest you leave the jargon till you know you are making sense!
With The minors and exotic currency pairs it is less easy to define which is which. But they are probably best described as ‘not majors’.
Minors Explained
For us, the top four here are minors and the bottom four, pairs that include less frequently traded currencies are the exotic pairs.
The minors include the currencies from the major pairs, but not paired with the USD. These are known as cross pairs. So EURGBP for example.
The exotic pairs include at least one less frequently traded currency from emerging or smaller nations or just nations whose currencies aren’t as favoured by traders. So the Turkish Lira, South African Rand, Norwegian Krone are examples.
Usually they are traded against the dollar but this is not compulsory and there can be some very interesting exotic trades out there.
But, the key thing is that usually currency trades involve the USD. If a currency trade does not involved the USD it is known as a cross pair
The USD operates as the World’s reserve currency - that means that nations and companies often stockpile dollars as it is seen as stable.
It is perfectly legitimate to trade a cross pair, that is, any pair that does not involve the USD, but the spread may be higher and the volatility greater depending on the pair.
Utilising minors and exotics in general can make for a useful trading tactic to maximise profit.
As an example
If you believe Pound Sterling is going up then normally you’d trade that against the dollar. But maybe you also think the JPY is going down. So if you trade GBP against JPY then you may make even more money as they will move in opposite directions!
For the beginner, we recommend minimising spread cost - which is best achieved by trading the majors. This will also mean you can focus on learning how the most common pairs move and react to news and technical analysis before venturing out if desired.
In this video you have learned how to write and price currency pairs, including the concepts of the base currency and quote currency, pips and pipettes and the difference between major, minor and exotic currency pairs.
We hope you enjoyed it, and please make sure you have fully understood currency pair pricing before moving on to the next video!