The foreign exchange (forex) market is the largest and most liquid market in the world with over $6.6 trillion in daily trading volume. At the heart of forex trading are currency pairs – pairs of currencies traded against each other based on their relative value. Understanding how currency pairs work is key to forex trading success. This comprehensive guide provides everything you need to know about currency pairs to trade them profitably.
What is a Currency Pair?
A currency pair quotes the value of one currency against another. It shows how much of the quote currency (second currency) is needed to purchase a unit of the base currency (first currency). The most commonly traded pairs are expressed in terms of USD, EUR, JPY, GBP, CHF, CAD, and AUD.
For example, the EUR/USD shows how many U.S. dollars are needed to buy one euro. If the pair is quoted as 1.2000, it means one euro equals 1.2 dollars.
The first currency in the pair is called the base currency, while the second is called the quote or counter currency. The base currency is always equal to one unit while the quote currency fluctuates in value relative to the base.
Types of Currency Pairs
There are three main classifications of currency pairs:
Major Pairs
These involve the USD paired with the EUR, JPY, GBP, CAD, CHF or AUD. Examples include EUR/USD, USD/JPY, GBP/USD. Majors have the highest liquidity and tightest spreads.
Minor Pairs
These pair a major currency with a currency from a smaller economy. Examples are EUR/CAD, AUD/JPY, EUR/AUD. Spreads are wider than majors but liquidity is decent.
Exotic Pairs
These pairs include a major or minor currency paired with the currency of an emerging economy. Examples are USD/PLN (Polish Zloty), GBP/MXN (Mexican Peso), EUR/HUF (Hungarian Forint). Exotics have wider spreads and lower liquidity.
What Moves Currency Pairs?
Many macroeconomic, geopolitical, and market sentiment factors influence the fluctuations in currency values and forex pairs. The main drivers are:
- Interest Rates – Central bank rate decisions affect capital flows and currency valuations. Higher relative interest rates attract foreign capital and drive up a currency’s value.
- Economic Data – Stronger than expected growth and positive data like employment and manufacturing boosts a currency. Weaker data depreciates it.
- Inflation – Rising inflation erodes purchasing power, so higher inflation typically weakens a currency.
- Political Events – Elections, referendums, reforms, and political stability affect currency values.
- Risk Sentiment – Geopolitical turmoil, financial crises, and risk aversion lead investors to safer currencies like CHF and JPY.
- Trade and Capital Flows – Currency valuations adjust to reflect the flow of capital and trade balances between nations.
Reading Currency Pairs
A currency pair quote, such as EUR/USD 1.1123, tells you three things:
- The base currency (EUR)
- The quote currency (USD)
- The exchange rate (1 EUR = 1.1123 USD)
If the quote rises from 1.1123 to 1.1243, it means the base currency has strengthened relative to the quote currency. Here the euro has strengthened vs the US dollar.
If the quote declines from 1.1123 to 1.0983, it means the base currency has weakened relative to the quote currency. Here the euro has weakened compared to the dollar.
The bid-ask spread is the difference between the buying (bid) and selling (ask) price quoted. The narrower the spread, the better for traders. Majors and crosses have the tightest spreads.
Long vs Short Positions
You can profit from currency movements by taking long or short positions:
Long Position – You buy the base currency expecting it to appreciate relative to the quote currency.
Short Position – You sell the base currency expecting it to depreciate compared to the quote currency.
If EUR/USD rises from 1.05 to 1.10, long traders profit. If it declines from 1.10 to 1.05, short traders profit. You close the trade to book your profits. Leverage amplifies gains and losses.
Cross Currency Pairs
Also known as “crosses”, these pairs do not involve the US dollar. Examples include EUR/JPY, AUD/NZD, and EUR/GBP. Since crosses lack USD involvement, they offer an alternative trading opportunity.
If EUR/USD and USD/JPY rise, EUR/JPY will also rise as EUR strengthens against USD and USD strengthens against JPY. The more USD-centric pairs you watch, the better insight you have on cross pairs.
Choosing a Base Currency
It is generally recommended to trade in pairs where the currency you are most familiar with is the base currency. For example:
- If you are based in Europe, trade EUR/USD where euro is the base.
- If you follow the British economy closely, trade GBP/JPY instead of EUR/JPY.
When the base is a familiar currency, it is easier to make informed trading decisions assessing its value relative to the quote.
Tips for Trading Currency Pairs
Here are some essential tips for effectively trading forex currency pairs:
- Watch for key technical levels that may trigger volatility.
- Be aware of major economic data releases that can cause sharp movements.
- Analyze the overall trend – use pullbacks within the trend to enter.
- For range-bound action, buy dips and sell rallies.
- Use stop-losses to limit downside risk on all positions.
- Don’t overleverage – use position sizing matched to your risk appetite.
- Stay up-to-date on macro fundamentals driving currency valuations.
- Adjust to changing market conditions – don’t stick rigidly to one strategy.
- Keep calm and stick to your trading plan during volatile swings.
Conclusion
Knowledge of currency pairs is essential to forex trading. The major, minor and exotic pairs each have their characteristics in terms of spreads, liquidity and volatility. Many drivers impact currency valuations – from central bank policies to economic data releases, inflation trends to geopolitics. Traders must understand how to analyze pairs, read quotes and identify trading opportunities. With the right strategies and risk management, currency pairs can be traded profitably over short and long-term time frames. The key is staying informed on the fundamentals and technicals to make sound trading decisions.