What is a Currency Pair?
Trading the foreign exchange market means trading currency pairs, so this is the very first notion one needs to understand before even considering trading. The purpose of this article is to make you familiar with what a currency pair is, and the logic behind pairing different currencies together, as well as to present the factors that make a currency pair move, and how a profit can be made. The overall Forex market is organised in currency pairs that are fluctuating 24/5, with the market being closed on Saturday and Sunday. This is just a formality, as many important events, either political or economic, happen during the weekend, and at the opening on Monday currencies will have gaps. In reality, it means that this market is actually monitored 24/7 as currency pairs move on very little. Having said that, currencies are paired with one another on the basis of their importance, and taking into account the US dollar, the world’s reserve currency.
Currency Pairs Classification
The first differentiation that is made is between major currency pairs and crosses. A major is a currency pair that has the US dollar as one of its components, the main representatives here being the EUR/USD, GBP/USD, USD/JPY, USD/CHF, and AUD/USD. Following the same logic, a cross is a currency pair that doesn’t have the US dollar as one of its components. Using the currency pairs listed above, examples of crosses are EUR/AUD, GBP/JPY, EUR/JPY, GBP/AUD, among others. In this way currencies are paired with the US dollar and against other currencies as well. This classification is extremely important as it shows the way the market is organised and the importance of these currency pairs. As a rule of thumb, major pairs are always more important than crosses for several reasons:
- Because it involves the world’s reserve currency, the US dollar, trading a major is more volatile than trading a cross. This stems from the fact that other important economies in the world are compared with the biggest one, the United States economy. It means that the currency pair will move aggressively on news from both sides of the currency pair. Let me give you an example. Let’s assume the CPI (Consumer Price Index = inflation) is released in the Eurozone, and it comes at a staggering 3% pace. This will trigger massive buying on the EUR/USD pair, as higher inflation implies that the central bank will hike rates on the next meeting, and interest rates are all that matters for a currency. However, on the same day, on the North American session, another important economic event may be announced, this time regarding the US economy, and with implications for the US dollar. Let’s assume the Federal Open Market Committee (FOMC) statement is released, and the Fed hikes the rates. This will make the EUR/USD pair reverse all of its previous gains based on the Eurozone inflation number, and so make new lows. These major pairs are volatile!
- The spread (the difference between the bid and ask prices) is always smaller on major pairs when compared with crosses. To give you an example, under the Electronic Communications Network (ECN) quotation, the spread on the EUR/USD pair can go as low as 0.2 depending on the broker, but on the AUD/NZD cross, there is always a spread of much bigger than 2.
Crosses, on the other hand, are not that volatile; but even under the crosses a difference should be made, as there are some that travel really slowly (AUD/NZD, AUD/CAD…) and some that move even faster than the majors (EUR/AUD, GBP/CHF, GBP/JPY…)
How To Make a Profit
As mentioned above, a currency pair always reflects two prices: bid and ask. The bid price is the one on the left side, while the ask price is the one on the right. Buying is always made at the ask price, and selling at the bid price. Let’s imagine we’re buying the EUR/USD at 1.1140, and the price moves all the way to 1.1160. Because the price moved to the upside after we bought the pair, a profit has been made. In order to close the trade and book the profit, we have to sell the pair or square the position. This is made on the bid price, and the difference between the bid and ask price is called a spread. Needless to say, currency pairs with a lower spread are more attractive than those with a bigger spread, and therefore brokers with lower and more stable spreads are favoured when compared with other ones.
What Makes a Currency Pair Move
When trading a currency pair, it is important to know what makes it move, and when a movement should be expected. Because of this, the economic calendar must be known in advance for the period ahead, such as for the day and week, in order to anticipate the move a currency pair is making. However, a currency pair does not move only in response to economic events, but also based on the old-fashioned supply and demand rule. If there are more traders who buy a currency pair, naturally the pair will move to the upside as a consequence. The opposite is true if more sellers dominate. In order to find out when to buy or sell a currency pair, traders use technical analysis. This allows identifying levels of support in a falling trend, or resistance in a rising one, as well as forecasting prices on the right side of a chart based on patterns that formed on the left side of it. Historical prices analysis can be made via trading theories, and for this one needs access to different pieces of information from different time frames. As a rule of thumb, the more information there is available on past prices, the more accurate the forecast of a currency pair is.
To sum up, come currency pairs are more or less important than others based on how fast they move or how far they travel, but the principle of trading the Forex market is the same for any currency pair: Buy or sell in order to make a profit.
Other educational materials
- Majors and Crosses – How to Trade Them?
- Leverage and Margin Requirements
- What is a Margin Call?
- Setting Up a Chart in Metatrader 4
- Forex Trading Accounts and the Value of a Pip
Recommended further readings
- What are Currency Pairs and the Basics of Currency Trading
- The euro as an international currency: explaining puzzling first evidence from the foreign exchange markets. Hau, H., Killeen, W., & Moore, M. (2002). Journal of International Money and Finance, 21(3), 351-383.