The Basics of Currency Trading

What are Currency Pairs?

A currency pair is the standard security that is traded in the foreign exchange market. The value of a currency pair is equal to the exchange rate which is calculated by dividing one currency by the other. The movements of currency pairs are based on market sentiment, which can deviate from second to second.

The first currency in a pair is known as the “base currency” and the second is the “quote currency” or “counter currency.” The base currency is the currency that you plan to buy or sell. The quote currency is the price you would pay for one unit of the base currency. For example, when a currency pair is quoted, it usually looks something like this: EUR/USD 1.3110. This means that in order to purchase one Euro, the buyer must pay US $1.3110. It also means that if a seller wants to sell one Euro, he will get US $1.3110 for it.

There are different rules that are used to calculate a currency pair depending on the type of product you plan to trade. The futures market has one set of rules while the over-the-counter (OTC) and contract for difference (CFD) markets have different rules.

Determining which is the base currency and which is the quote currency is formulated from rules that are set out by the OCD market. The Euro is generally first on the pecking order when it comes to base currencies. Commonwealth currencies, including the British pound, are next. The bottom end is the emerging currencies which are usually the first quote currencies.

How do you Buy and Sell a Currency Pair?

When you trade in the forex markets, you are selling one currency and simultaneously buying another currency. Generally, you will see a bid-offer spread when you attempt to purchase or sell a currency pair. The bid is where market participants want to purchase a security, and the offer is where the market wants to sell an asset. 

For example, if you sell the Euro versus the US dollar which might be quoted as EUR/USD 1.3110/12, the quote is telling you that the bid exchange rate is 1.3110 and the offer exchange rate is 1.3112. The smallest increment that a currency pair trades in is referred to as a Pip. The amount by which the asking price exceeds the bid is known as the bid-ask spread. In the example of the EUR/USD, the bid-ask spread is two pips.

If you want to buy immediately, you would need to pay the price of the offer. The reverse is true if you want to sell immediately. The price that you receive when you purchase or sell is referred to as the spot price which settles in two business days. There are some currencies that allow you to deliver in one business day and those exchange rates are referred to as tom-next (tomorrow next) rates.

How do you Settle a Currency Transaction?

There are several ways that a currency transaction can settle. If you trade futures, CFDs and exchange-traded funds (ETFs) to initiate currency market exposure, you do not need to settle your currency exposure, it is incorporated into the settlement process of the security.

CFDs track the movements of currencies so the settlement is your profit or loss. Most futures are financially settled which means that you just exchange the difference in the price. ETFs trade like stocks so the settlement is the value of the exchange-traded fund. Most of the currencies that are traded for the purpose of speculation are non-deliverable forward trades. This means that you will never actually need to exchange one currency for another.

If you are trading over the country forex markets, you might have deliverable positions. This means that you are expected to exchange one currency for another. You would swap the currencies at the value of the transacted exchange rate. The OCD market also provides a forward rate market. This is a physical settlement in the future. To calculate your forward rate, you would add/subtract what is called forward points to your spot rate. You would be obligated to make a physical settlement on the forward date. Of course, you could extend the date by entering into another forward contract if you want to hold onto the position.

Can you use Leverage to Trade the Forex Markets?

One of the advantages of trading the forex markets is that most trading vehicles provide some type of leverage. Leverage is the ability to borrow capital to enhance the size of your position. To borrow capital, you need to either have a margin account or have access to products that embed leverage in them.

If you are trading over-the-counter currencies or futures, you will need access to a margin account to enhance your leverage. You need to apply for this type of account as the company is providing you with a loan. If you are trading CFDs, the leverage that is used is incorporated into the value of the contract for differences.

What Strategies can you use to Trade the Forex Markets?

Most traders use a combination of fundamental and technical analysis to forecast future movements of a currency pair. Fundamental analysis is the study of new information and how it will affect the price. Technical analysis is the study of past prices to help you forecast future prices. Both are a combination of art and science. Technical analysis includes the evaluation of support and resistance levels, momentum, trend following, and mean reversion. Fundamental analysis focuses on macro events such as economic releases as well as monetary policy changes.

Summary

The forex market is the largest and most liquid market in the world with 5-trillion in notional value traded every day. The exchange of currency is a necessity for countries to trade with one another around the globe. In addition to trading, currency transactions are used to hedge exposure as well as to speculate. To be successful in currency trading, it’s worthwhile to spend time increasing your knowledge of the subject and establishing a trading strategy to help you forecast the future direction of a currency pair.