Foreign exchange (forex) is the largest and most liquid market in the world, with over $5 trillion traded daily. When trading currencies, forex traders always specify a base currency and a quote currency to establish currency pairs for trading. The base currency serves an important function in forex trading and has implications for profit and loss calculations.
In this comprehensive guide, we’ll explain what base currency means, how it works, and why it matters for your forex trading strategy and money management.
What is Base Currency in Forex?
In the forex market, currencies are quoted in pairs like EUR/USD or USD/JPY. The first currency in a forex pair is called the base currency, and the second is called the quote or counter currency.
For example:
- EUR/USD: EUR is the base currency and USD is the quote currency
- USD/JPY: USD is the base currency and JPY is the quote currency
The base currency is used as the reference point for quotes, pricing, and trading. When looking at a currency pair quote, the value is how much one unit of the quote currency costs in the base currency.
For EUR/USD quoted at 1.1200, one USD costs 1.1200 EUR. Traders analyze the relative value of the base currency vs the quote currency when deciding to buy or sell a currency pair.
Why Base Currency Matters
The base currency in a forex pair determines quite a few important factors for your trading:
1. Trade P&L Calculations
Profit or loss from a forex trade is calculated in the base currency. For example, if you buy EUR/USD, gains and losses are calculated in EUR. If you close out a long EUR/USD trade for a 1,000 pip gain when held at standard size of 100,000 units, that equates to a €10,000 profit since EUR is the base currency.
2. Lot Sizes
Standard forex lot sizes are denominated in the base currency. For EUR/USD, the standard lot size is 100,000 units of the base currency, which is €100,000 for this pair. For USD/JPY, the standard lot size is $100,000. Lot sizes for exotic pairs may be lower since currencies with higher value per unit are often the base.
3. Account Statements
Forex account statements will show balances in the account’s base currency, which is chosen when opening the account. All profits, losses, deposits, and withdrawals are rolled up into the base currency balance.
4. Margin Requirements
Margin requirements from brokers are typically calculated in the base currency. For 50:1 leverage in trading EUR/USD, the margin requirement is €2,000 per standard lot. Margin requirements remain constant in the base currency, even as exchange rates fluctuate.
5. Currency Conversion for Deposits/Withdrawals
Depositing or withdrawing funds from a forex account often requires converting to/from the base currency. Traders must account for conversion rates if the account base currency differs from their bank currency or the currency they wish to deposit/withdraw.
As you can see, the base currency serves as an anchor for all critical calculations in forex trading. It’s essential for traders to understand and account for the base currency in order to properly interpret trading results and manage risks.
How Base Currency is Determined
So how is the base currency even determined for a forex currency pair in the first place? There are a few key criteria used:
1. Major/Minor Currencies
In general, major currencies like the US dollar, Euro, Japanese Yen, and British Pound are used as the base in currency pairs. The major currency acts as the baseline value, while the minor currency fluctuates in relation.
2. Higher Value Currency
Between two major currencies, the one with higher relative value per unit is typically the base. EUR/USD shows this, with 1 EUR worth more than 1 USD.
3. Most Traded Pair
For currency pairs that are actively traded in both directions, forex convention is to show the most common quote direction as the standard pair. EUR/USD and USD/JPY are far more commonly traded than their counterparts (USD/EUR, JPY/USD), so the major currencies serve as base.
4. Fixed Exchange Rates
In some currency regimes like pegs or currency boards, the anchor currency is always the base. For example, the Hong Kong Dollar is pegged to the US Dollar, so USD/HKD clearly shows USD as base.
While conventions exist, brokers can show certain currency pairs with either currency as the base. So always verify which is the base currency for the pair you’re trading.
Impact of Base Currency on Trading Strategy
The base currency has practical implications traders should incorporate into their strategies and money management:
1. Performance Benchmark
With profit/loss calculations tied to the base currency, it becomes the natural benchmark for measuring performance. Traders can more easily assess if they are achieving profit targets when the base currency remains constant versus changing pairs.
2. Account Sizing
Consider sizing forex accounts primarily based on the base currency and aimed margin requirements, not the quote currencies traded. Margin requirements remain fixed per standard lots in the base currency.
3. Currency Risk Management
With balances and calculations tied to the base currency, traders must watch exchange rates moves between the base currency and quote currency traded. Appreciation of quote currencies vs the base poses risks.
4. Hedging Approaches
Consider hedging currency exposure based on the account base currency if actively trading multiple pairs with exposure outside of the account base currency.
Examples of Base Currency in Action
Let’s walk through a few scenarios to see the base currency mechanics in action:
EUR/USD Trade with EUR Base Account
If trading a long 100,000 EUR/USD position with EUR as the account base currency and the pair rises 100 pips from 1.1500 to 1.1600, the gain is €1,000 (100 pips x 1.1600 rate x 100,000 EUR position size).
USD/JPY Trade with EUR Base Account
If trading a long 100,000 USD/JPY position with EUR base currency, and the pair rises 100 pips from 110.00 to 111.00, the equivalent EUR gain depends on USD/EUR conversion rate. At a rate of 1.1500, the USD gain of $1,000 converts to approximately €870 EUR gain.
Hedging USD/JPY Exposure in EUR Account
When short USD/JPY, traders with EUR base currency accounts can hedge USD exposure by going long an equivalent EUR/USD position. As USD/JPY falls from 110.00 to 109.00, short gains of $1,000 are offset by a €870 unrealized loss on the EUR/USD long hedge as EUR weakens against USD.
Choosing a Base Currency
When opening a forex account, one of the decisions is which currency to use as the account base currency. Here are some tips on choosing a base currency:
- Select your domestic currency if available to avoid conversion fees and risks
- Match base currency to any currencies you plan to primarily hold as balance
- Consider currencies with lower interest rates as base to reduce swap costs
- Research broker requirements and benefits tied to base currencies
- Evaluate currency risks and volatility tied to different base currency options
The base currency sets the foundation for your forex account and trading calculations, so choose carefully based on your needs as a trader.
Final Thoughts on Trading with Base Currency
Understanding the mechanisms of base currency in forex is key to properly interpreting performance, managing risks, and developing effective trading strategies. When trading currency pairs, always note which currency is the base and account for how that impacts your trade calculations and money management.
Base currency serves as a constant backdrop that allows traders to assess performance, risks, and opportunities across trading any currency pairs. By learning to incorporate base currency conventions into your forex approaches, you’ll trade with clearer perspective and improved discipline.
Over time, carefully tracking results calculated in your base currency will provide the ultimate measure of your development and progress as a forex trader.
