The foreign exchange market, also known as forex or FX, is the largest financial market in the world with over $6.6 trillion traded daily. At the heart of forex trading are currency pairs, which allow traders to speculate on the relative value between two currencies. Understanding what currency pairs are and how they work is foundational knowledge for forex traders.
This comprehensive guide will provide an in-depth look at currency pairs including what they are, how they are quoted, what moves them, major pairs versus crosses, carry trades, and how traders analyze and trade the currencies. With the right knowledge, forex traders can better understand the mechanics behind currency pairs and improve their trading.
What Are Currency Pairs?
A currency pair quotes the relative value of one currency to another currency. It indicates how much of the quote currency (second currency) is needed to purchase one unit of the base currency (first currency). The most commonly traded pairs usually involve the major world or reserve currencies such as the U.S. dollar (USD), Euro (EUR), Japanese Yen (JPY), British pound sterling (GBP), Australian dollar (AUD), Canadian dollar (CAD), and Swiss franc (CHF).
For example, the EUR/USD currency pair quotes how many U.S. dollars it costs to buy one euro. If the EUR/USD exchange rate is 1.1000, one euro can be purchased for 1.10 U.S. dollars. Traders can speculate on the movement of currency pairs by buying (going long) a pair if they expect it to rise, or selling (going short) a pair if they expect it to fall.
Currency pairs always consist of two currencies and are typically shown with a slash (/) separating them. The first listed currency is called the base currency, while the second is called the quote or counter currency. The price quoted is how much of the quote currency is needed to buy one unit of the base currency.
How Currency Pairs Are Quoted
There are two conventions for quoting currency pairs:
American Terms
This quotes currency pairs from the perspective of how many U.S. dollars are needed to buy one unit of the other currency. For example, the EUR/USD rate of 1.1000 means 1 euro costs 1.10 U.S. dollars. This is how currency pairs are typically quoted in North and South America.
European Terms
European terms flips the quote to show how many units of the quote currency are needed to buy one unit of the base currency. Using EUR/USD again, the euro rate would be quoted as 0.9091 euros per 1 U.S. dollar under European terms. This flips the perspective to how many euros it costs per dollar instead of dollars per euro.
The market convention is to quote most currency pairs in American terms, meaning the USD is the quote currency. However, pairs that don’t involve the dollar are often quoted in European terms with the most liquid traded currency as the quote. either quoting convention will ultimately get you to the same relative value between the two currencies.
What Factors Influence Currency Pair Prices?
Many factors can cause the prices of currency pairs to move up and down. Traders analyze these economic factors to predict future price movements. The main factors that move currencies include:
- Interest Rates – Central bank interest rate changes and expectations move currencies strongly. Higher rates tend to boost that country’s currency by attracting foreign capital flows.
- Economic Growth – Stronger economic growth and outlook will tend to lift a country’s currency. Weaker growth depreciates it.
- Inflation – Rising inflation typically devalues a currency while falling inflation appreciates it.
- Political Factors – Elections, new governments, fiscal policy all influence currency valuations.
- Trade Flows – Trade surpluses and deficits impact demand for a currency. Large surpluses tend to boost while deficits weaken.
- Risk Sentiment – In times of stability currencies seen as risky tend to underperform safe havens like the dollar and yen.
As economic conditions change, so do the supply and demand dynamics for currencies resulting in up and down fluctuations in exchange rates. Trading currency pairs allows speculating on these moves.
Major Currency Pairs vs Crosses
The most actively traded currency pairs in forex all involve the U.S. dollar on one side, paired against another major currency. These major pairs include:
- EUR/USD (Euro/U.S. dollar)
- USD/JPY (U.S. dollar/Japanese Yen)
- GBP/USD (British pound/U.S. dollar)
- USD/CHF (U.S. dollar/Swiss Franc)
- USD/CAD (U.S. dollar/Canadian dollar)
- AUD/USD (Australian dollar/U.S. dollar)
The combination of high liquidity, extensive market hours and low trading costs makes these seven pairs ideal for forex beginners to start with. Since they all contain the U.S. dollar, major currency pair prices also tend to closely correlate with each other.
Currency crosses, sometimes called minors, are pairs that do NOT contain the U.S. dollar. Examples include EUR/GBP, EUR/JPY and GBP/JPY. While crosses are traded actively by speculators, their generally lower liquidity makes them better suited for experienced traders.
Carry Trades with Currency Pairs
Carry trading involves buying high interest rate currencies funded by low rate currencies. The strategy earns traders the interest rate differential, or carry, between the two currencies.
Popular carry trades include buying AUD, NZD and CAD against funding currencies like the JPY. Since Down Under and Canadian dollars offer higher yield than yen, carry trades profit from the rate difference. However, carry trades lose when the high yield currency depreciates, so traders must weigh rates versus currency outlook.
Analyzing Currency Pairs
To profit trading currency pairs, forex traders employ technical, fundamental and sentiment analysis to identify trading opportunities. Here are some of the main techniques:
- Technical Analysis – Analyzing past price charts and indicators to forecast future moves. Common methods include trend, momentum, volatility and cycle analysis.
- Fundamental Analysis – Evaluating economic factors like growth, interest rates and politics to estimate currency valuations. May involve macro or micro analysis.
- Sentiment Analysis – Assessing market positioning among retail traders and large speculators to gauge price contrarian trades. Data comes from the CFTC Commitment of Traders reports.
- Statistical Analysis – Looking at historical pricing relationships and distributions to identify mean reversion trades or volatility opportunities. Uses methods like correlation and cointegration.
- Algorithmic Analysis – Developing automated trading systems using machine learning, neural networks and AI to find non-random patterns.
Whichever markets, currencies or analytic methods they trade, forex traders all rely on identifying buying and selling opportunities in currency pair fluctuations.
How to Trade Currency Pairs
Once attractive trading opportunities arise, forex traders can act by speculating on currency pair price movements. Here are some of the main ways to trade:
- Spot Market – Taking outright long or short positions to profit from rising or falling currency pairs.
- Futures – Using currency futures contracts traded on exchanges to hedge or speculate with leverage.
- CFDs – Trading Contracts for Difference on margin with brokers to profit from price moves without owning currency.
- Options – Buying options contracts like calls and puts to capitalize on directional moves for limited risk.
- Spreads – Simultaneously buying one currency pair while selling a correlated pair to hedge exposure.
- Automated Trading – Developing or using expert advisors and algorithms to systematically trade pairs 24/5.
With low costs, extensive leverage up to 100:1 and the ability to profit in falling markets, currency pairs offer traders significant speculative opportunities. By applying sound risk management and developing robust trading strategies, traders can aim to consistently profit.
Conclusion
From major pairs like EUR/USD and USD/JPY to crosses like EUR/GBP, currency trading is ultimately centered around fluctuations in exchange rates between national monies. Traders buy and sell forex pairs based on economic factors, analysis techniques and trading strategies.
By taking the time to learn what Forex currency pairs are, how they behave, what moves prices and how to apply analytics, traders can gain valuable skills. With practice and discipline, speculating on currency pair moves provides an exciting opportunity for generating trading income.