For most beginners, the most complicated aspect of Forex trading is not the volatility of the markets, but understanding how currency trading actually takes place and how to dip your oar into its waters.
The common mistake is to assume that it’s a simple form of trading because it’s top level – you’re not dealing in what money can buy, you’re dealing in the money itself. However, the market does not actually work with individual currencies.
Instead, it works with what is known as “currency pairs”. While there are only around 180 currencies in the world, these can be paired in literally thousands of different ways because, as we’re about to find out, it matters which order they are paired in and therefore whether you are dealing with GBP/USD or USD/GBP.
For instance, you might be working with the British pound and the U.S. dollar, a pair referred to as GBP/USD. You could be working with the New Zealand dollar and the U.S. dollar together, which would be referred to as NZD/ USD.
Along with the pairings is the meaning associated with their order. It does, indeed, a matter which currency is listed first in a pair and which is listed second.
The first currency listed in the pairing is the “base currency”. It always represents a total of one and therefore is the stable base on which a trade is found. The base currency is used to figure out the answer to, “One of these equals X amount of that”. In other words, if GBP is the base currency, one British pound is equal to X yen, X Canadian dollars and so on.
The second currency listed in the pairing is the “quote currency”, and this is the one that alters to reflect the relationship between the two currencies in the pairing. The higher it is, the most of that second currency you will receive if you trade it with some of the base currency. For instance, if one GBP equals 1.4 USD, then for every British pound you trade you will receive $1.40 in American dollars.
This is where the jargon starts to get complicated. When you trade on the Forex market, you will either “bid” or “offer/ask”.
- To bid means that you are selling the base currency on the left side of the pairing in exchange for the quote currency on the right-hand side of the pair. In other words, you are buying the base currency and selling the quote currency.
- To offer/ask, you will buy the base currency on the left of the pair in exchange for selling the quote currency on the right-hand side of the pair. In other words, you are selling the base currency and buying the quote currency.
It’s absolutely crucial to memorize the difference between bids and ask because what you’ll get out of a trade depends entirely on the relationship between the two currencies. Get it the wrong way round and you’ll make a loss where you thought you were making a profit.
You will also need to know that the Forex market specifically deals with how the value of the two currencies in a pair are changing. If the value of one is increasing, however, it doesn’t necessarily mean that the other is decreasing. Though the two are paired in the trade, they are not solely going to be influenced by each other – you are simply removing two small cogs from the giant machine and holding them up against each other at a particular moment in time. What’s happening in the rest of the machine (and, indeed, what’s happening to that cog itself) is also going to influence its value.
The speed at which the two currencies are changing is also not always going to match. Just because the U.S. dollar is increasing fast in value doesn’t mean the Canadian dollar is increasing at the same rate. This is where knowledge of the currency market comes into play. Simply looking at the pairing isn’t going to tell you much about how it’s going to look later in the day when certain markets close. You will need to look at the overall trend of the individual currencies to figure that out.
Obviously, the clearest trades are going to happen when one currency is weakening against the other, allowing you to buy or sell the weak currency at a great price. However, you can also make a profit when both are strengthening, if they are doing so at different speeds.