Understanding Currency Pairs in Forex Trading
Exploring the Basics of Buying and Selling Currencies and the Impact of Relative Strength and Weakness
Currencies are traded in pairs because the value of a currency is always relative to the value of another currency. In other words, the value of a currency is determined by comparing it to another currency. When trading currencies, you are essentially betting on the relative strength or weakness of one currency against another.
A currency pair is the quotation of two different currencies, with the value of one currency being quoted against the other. The first listed currency of a currency pair is called the base currency and the second currency is referred to as the quote currency. For example, in the currency pair EUR/USD, EUR is the base currency and USD is the quote currency. This means that the value of one euro is being quoted against the value of one U.S. dollar.
When trading currency pairs, the base currency is being bought while the quote currency is being sold. For example, if you were to buy the EUR/USD currency pair, you would be buying euros and selling U.S. dollars. Conversely, if you were to sell the EUR/USD currency pair, you would be selling euros and buying U.S. dollars.
Currency pairs are quoted based on their bid (buy) and ask (sell) prices. The bid price is the price at which the forex broker will buy the base currency from you in exchange for the quote currency. The ask price is the price at which the broker will sell you the base currency in exchange for the quote currency. The difference between the bid and ask prices is known as the spread.
A widely traded currency pair is the euro against the U.S. dollar, also known as EUR/USD. It is the most liquid currency pair in the world because it is the most heavily traded. The quotation EUR/USD = 1.2500 means that one euro is exchanged for 1.2500 U.S. dollars. In this case, EUR is the base currency and USD is the quote currency. Another way of looking at this is that it will cost you $125 to buy 100 euros.
As an example, let’s say you believe that the U.S. dollar will strengthen against the euro. You would buy the currency pair EUR/USD, which means you are buying euros and selling dollars. If your prediction is correct and the value of the dollar rises against the euro, the value of the EUR/USD pair will decrease, and you can then sell the pair for a profit.
Another example would be if you believe that the British pound will weaken against the Japanese yen. You would buy the currency pair GBP/JPY, which means you are buying pounds and selling yen. If your prediction is correct and the value of the pound falls against the yen, the value of the GBP/JPY pair will decrease, and you can then sell the pair for a profit.