A detailed guide to trading currency pairs in Forex
Today, I am going to deal with one of the most popular questions. What is a forex currency pair? In addition, I will also answer some other questions. What are the most popular currency pairs? How to trade fx currency pairs? What are major currency pairs? And, of course, I will write a detailed guide to making an accurate forecast for Forex movements.
What is a Forex currency pair?
To answer this question, we need to go back to the basics, to the very concept of foreign exchange market. In Forex, there are contacted transactions with currencies, foreign exchange transactions.
We all come across such transactions, when we go the bank to exchange our local currency for a foreign currency, when we are going on holiday. Are you going to Europe, but you live in the USA? You take your US dollars and go to the bank to exchange them for euros. Any bank that provides currency exchange services is an element of the global foreign exchange. In the bank, you should learn the exchange rate to see how many dollars you have to pay to get the needed amount of the euros. It usually looks like this:
EUR/USD = 1.20000
Undoubtedly, this equation is familiar to everybody. It denotes the value of one currency in terms of another. And it says that 1 EUR is 1.2 USD. Thus, if we want to buy 1000 EUR, we need to pay 1200 USD. This is the currency pair. A currency pair is the value of one currency expressed in another currency.
Let’s discuss the currency pair in more detail and see what it consists of:
The above figure presents the EUR/USD pair. Any currency pair consists of three major elements: the first listed currency is called the base currency, and the second currency is called the quote currency, and the quote is the exchange price. This pair is one of the most traded currency pairs by volume in the world, I will write about it more a little later. The most important element of a currency pair is its quotation or exchange rate. The quotation can be simple (two-digit) and exchange market one (five-digit). The number of decimal numbers in the quote depends on the type of its use.
If exchange operations are conducted with small amounts of currency, a simple quote is used, for example: USDRUB = 65.30. This type of quotes is most common in everyday life in various exchangers. And, if it is necessary to make a very large-volume exchange transaction, the exchange market quote is applied, for example: USDRUB = 65.30234. In both cases, this is the same quote, only for different volumes of transactions. If we change 100 USD, then at a simple quote we will get 65.30 * 100 = 6530 RUB. And if the company changes 1000000 USD, then for a simple quote, it will receive 65.30 * 1000000 = 65300000 RUB. And according to the exchange market quotation: 65.30234 * 1000000 = 65302340 RUB. So, the transaction will count for 2340 RUB more than in a simple quote. And what if 1 billion is exchanged? Of course, it is also necessary to take into account the commission, the spread, but I have already written about this in this article.
You are likely to know that the USD is the U.S. dollar and the EUR is the euro, but how do you understand other symbols? For example, NZD, AUD? Let us study the abbreviations in more detail.
The above figure presents a fairly detailed explanation of short names of major currencies. The short exchange name of a currency is called a ticker in the financial world. Well, everything is quite simple: the first two letters of a ticker is the name of the country of this currency, and the third letter is the first letter of the currency’s name. It is clear with major currencies. Let us define not so popular currencies. For example, HKD, SGD, HUF, NOK. HKD stands for Hong Kong Dollar, SGD means SinGapore Dollar, HUF is HUngarian Forint, NOK — NOrwegian Krone. If know how the ticker’s name is made up, you don’t even need to learn each of them.
Why do currency pairs rise and fall?
So, you understand the concept of a currency pair, don’t you? Now, it is time to discuss how all this looks in the chart and how it affects the price. A currency pair is a financial instrument; and the main purpose of trading any financial instrument is making profit.
Speculators treat currency pairs as stocks or commodities, they sell and buy them to take profits from this process. And so, currency pairs, just like any other trading instruments, have particular causes to rise or fall.
Since the currency pair is a ratio of two different currencies, the reasons for the rise and fall will depend on the currencies. Let’s consider the main reasons for the growth of a currency pair, for example, AUDUSD:
- The Australian dollar is appreciating, but the U.S. dollar isn’t changing in value.
- The Australian dollar is not changing in price, but the U.S. dollar is depreciating.
- The Australian dollar is appreciating, the U.S. dollar is falling in price.
- Both the Australian dollar and the U.S. dollar are rising in price, but the AUD is growing faster.
- Both the Australian and the U.S. dollars are depreciating, but the US dollar is falling faster.
These are the basic causes for rising or falling of a currency pair, but the reasons for growth or fall of a particular currency should be studied separately.
Types of currency pairs
There is a huge number of different types of currency pairs, but the main classification is the grouping into major, minor and exotic currency pairs.
- Major currency pairs. Major currency pairs consist of the most frequently traded currencies globally. Major currency pairs include pairs which consist of the US dollar and another currency of a developed country. At the moment there are seven major pairs: EURUSD, USDCHF, GBPUSD, AUDUSD, NZDUSD, USDJPY, USDCAD. Major currency pairs are divided into direct quotes and reverse quotes. Everything is simple, direct ones are pairs in which the U.S. dollar is the base currency, and the reverse quotes are those in which the US dollar is the quoted currency. Why does everything depend on the us dollar? The dollar is the world’s leading reserve currency, and it’s involved in about 88% of currency trades. You’re able to trade major currency pairs virtually always. These are the most popular among interactive brokers currency pairs. Furthermore, you’ll find the lowest spreads — or brokerage costs — when trading these pairs. The reason is simple, these are most traded currency pairs by volume globally and they are involved in 90% of all Forex trades. So, there is no need in large spreads, brokers already receive great incomes due to the amount of transactions.
- Minor currency pairs. When a currency pair doesn’t include the US dollar, it’s called a minor currency pair or a cross currency pair. Although the definition of a cross-currency pair is a little different. Cross-currency pairs are currency pairs in which there is no direct or indirect relation to the US dollar. Minor currency pairs are just not so popular pairs, most often, they are popular cross-currency pairs, for example: AUDCAD, AUDNZD, EURGBP, EURJPY. The problem with trading cross-currency pairs is that the calculations are rather complex than for the major ones. Minor currency pairs are less liquid and so, you will find higher spreads than for major pairs. As minor pairs are less traded, brokers have to increase the commissions to keep the incomes at the same level.
- Exotic currency pairs.I may say that this group includes all the rest of forex currency pairs. There, you may find both pairs including the U.S. dollar and the least liquid cross-currency pairs. For example, USDSEK, USDTRY,NZDSGD. These currency pairs are traded by a very small number of traders and they are mainly used for hedging transactions. That is why, you’ll find the highest commissions for trading such pairs. The commissions are sometimes so high that it is unprofitable to trade at the intervals of more than a week. In addition to commissions, these pairs have the lowest cost of the price unit.
Classification based on direction of movement
Basically, any trading instrument, a currency pair, a stock or any other one, is just a certain money supply that is present in the market. And this money supply doesn’t change a lot, it is just floating from one asset into another. If the capital is invested in oil, then the volatility will increase, and this asset will be trending.
Sometime later, the capital will outflow from the oil market because the desired result will be achieved, and the asset will not be able to yield more profits. Why? Imagine that oil costs 30 USD. It is attractive for big money, because a small change in price yields a huge profit in percentage terms. If, a week later, oil will cost 40 USD, then this is an increase of only 10 USD.
So, big traders always think in percentage terms, rather than in numbers. 10 USD is a 25% growth. Therefore, an investor receives a 25% return on the invested capital. And this is huge profitability! Now, let us study another example. Imagine that oil costs 100 USD
The price again rises by the same 10 USD. But now it is not 25%, it is just 10%. It is of course also a high yield, but it is less interesting. Well, when an asset ceases to yield high returns, it will become less interesting, and investors will look for a new asset that can generate greater returns. Money outflows from the asset, volatility falls, and the trend exhausts. But money does not leave the market at all, it simply flows into another asset. So, a new asset will feature high volatility and a strong trend.
In Forex, capitals flow in a similar way, but there is a little difference. Investors rarely look for a single currency pair, they invest their capitals in a group of trending currency pairs that will react to a rise in volatility concurrently. It is a kind of a simple hedging mechanism. Money is allocated between a few pairs that are trending in the same direction.
Currency pairs that move in the same direction (positive correlation)
Currency pairs that move in the same direction have a correlation coefficient of +1. There are a lot of such pairs, and most often these are pairs in which the same currency is included in relation to different ones. For example: EURJPY and USDJPY. In both pairs, the quoted currency is JPY. And, if the Japanese currency will grow against to all currencies, then both currency pairs will decline.
It is clear from the above chart these currency pairs are moving in sync, though there are some divergences in the short term. These divergences result from differences in the price swings of EUR and USD, and from different degree of the JPY influence in these pairs. We can also add to this list such pairs as GBPJPY, CHFJPY, AUDJPY… Therefore, if you invest in some of these pairs, you will have a portfolio that consists of pairs moving in the same direction. To reduce the amount of risk, you allocate your capital among these pairs. Finally, you will trade the pairs that always move in the same direction. This is a very effective strategy, where there will always be leading pairs and the pairs, lagging behind, and this is already the room for maneuver.
Currency pairs that move in opposite directions (negative correlation)
Currency pairs that almost always move in opposite directions have a negative correlation. The simplest example is the direct and indirect quotes of the US dollar. The most popular opponent pairs are: EURUSD and USDCHF. A lot has been said about the relationship between these two pairs and many books have been written. In the foreign exchange market, these pairs are most often chosen as a tool for hedging (overlapping). Let’s see what other opponent pairs look like, for example, EURAUD and AUDCHF
As you can see, such pairs almost always move in opposite directions. And if you buy theEURAUD, and you need a simple insurance, like a “lock” popular among beginners, you do not need to open a sell position for the same pair. You need to open a buy position for the AUDCHF pair. Such a “lock” is much more effective, because the pairs move at different speeds. Because of these differences, you can also make a profit, rather than just block the position.
How to trade currency pairs
Trading currency pairs in forex has its peculiar features when compared to stocks, for example. To make up a profitable forex trading strategy to trade currency pairs, you need to consider a few points;
1. Trading Hours. When you trade fx currency pairs intraday, one of the most important things is to take trading hours into account. As you know, forex operates 24 hours a day, but trading activity and volume by currencies is different and mostly depends on the time.
As you see from the above figure, currency trading activity depends on the time of day. When the exchange, for which this currency is the major one, operates trading is more active.
2.Volatility. Volatility is the number of changes in the price of an instrument per unit of time. The more swings a currency price makes, the higher the volatilityis. In the forex market, volatility is pegged to points or pips. As we already know, a point (pip) is the minimum change in the price of a currency pair. If a currency pair has passed 600 pips per day, it is considered that the volatility of the pair is 600 pips.Volatility depends on a large number of different factors; the main ones are the trading hours from the paragraph above and the fundamental factors for each of the currency pairs. Fundamental factors are, for example, important news. For example, at present, there are often appear news bits about Brexit. Since the procedure itself is the relationship between the Eurozone and the UK, this news has the greatest impact on the currencies of these countries — EUR and GBP. For example, in the days when the news concerning this topic was published, the volatility of the EURGBP pair increased to 1300 pips, with a standard value of 350 pips. High volatility provides great opportunities for making profits. You will not earn anything on pairs whose volatility is extremely low. The most volatile forex pairs are almost all major pairs. This is logical, they are the most popular, attract more money, hence the volatility. The least volatile pairs are exotic currency pairs. There is only one reason that is high commissions, and therefore, low appeal. But their volatility also sometimes surges.
3.Information. General awareness of information is another major factor that affects your trading performance. If there is too little information on the currency you are trading or it is the same, then the volatility of this pair is likely to be very low, and there will less opportunities to earn. When it comes to information, fundamental analytics is mostly implied. Fundamental analytics of forex pairs is rather monotonous and does not require deep knowledge of the topic.Main drivers for forex movements currency pairs are the economic data for the country that issues the currency. There are not so many of major economic indicators, they are: GDP, trade balance, consumer price index, employment and interest rate. All these indicators have long been monitored on special resources and combined into economic calendars.
In economic calendars, news is divided by publication time, currency affected by the news, importance, name of the event itself and actual / forecast values. The principle is simple — various analytical agencies publish their forecasts for the major economic indicators.
If the actual value exceeds the forecast, the news is positive and may be interpreted by the market as a potential growth driver for the currency. It is thought that the forecasts have already been priced in a currency rate, and the movements occur because of the actual data. I can say for sure how often this works out, but I know a few traders who only trade on the news. As for the currencies themselves, they are affected by different factors in different ways.For example, the USD is strongly affected by the data on the U.S. jobless claims. When this report is published, there is often an increase in volatility for the currency pairs that include the USD. The EUR is quite responsive to any information concerning any changes of the ECB interest rate. Even if the rate is retained the same, currency pairs including the EUR may feature quite strong movements. The GBP is mostly affected by Brexit and political events in the UK.
4. Analytics. Another important point is reading different analytical materials. Is is easier and more convenient to rely on the experts’ opinion. It is only important that you read the analytics published by real professionals. Now, almost every large broker has quite a developed analytical platform that provides analytical overviews on time. For example, on LiteForex platform, general analysis for currency pairs is integrated into the client profile.
There is also special Trader Blog, where reputable forex analysts publish analytical and training articles daily. There is a special free app with daily analysis and many other useful functions. It is up to you, whether to follow analytics or to trade on your own. I always say that the best analyst is you yourself. So it depends on your choice.
Originally published: https://www.liteforex.com/blog/for-beginners/forex-currency-pairs/
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