A Complete Guide of Understanding Currency Pairs and How They Work

Learn everything about currency pairs in forex trading. Discover major, minor, and exotic pairs, pricing, bid/ask spread, and trading strategies. A complete guide!

1.   Introduction To Currency Pairs

Forex trading, also known as foreign exchange trading, is the one market that is so vast that it can accommodate as much as $7.5 trillion worth of currency trading every day. The basic idea of forex trading is currency pairs. These pairs are the exchange rates of two currencies against one another.

For traders, understanding how currency pairs operate is vital to making informed trading decisions. This guide sheds light on the kinds of currency pairs, their functions, and strategies that can be used to trade them profitably.

2.   What is Currency Pair?

A currency pair includes two currencies quoted with respect to one another, where the first denotes the base currency and the second is termed as quote currency. From this, the rate of exchange tells how much of the second currency is needed to get one unit value of the first currency.

For example, Currency Pair:

A currency pair is shown in this manner:

•   EUR/USD = 1.2000, which means to say 1 Euro = 1.20 US Dollars against it.

Depending on volume traded and liquidity, currency pairs are thus divided into two main groups.

3.   Types of Currency Pair

Major Currency Pairs

Major pairs refer to the most traded currencies with high liquidity. Examples of major currency pairs include:

•  EUR/USD (Euro/US Dollar)

•  USD/JPY (US Dollar/Japanese Yen)

•  GBP/USD (British Pound/US Dollar)

Minor Currency Pairs

In minor currency pairs, there are no US dollars, but major currencies are used. By way of illustration:

• EUR/GBP (Euro/British Pound)

• AUD/CAD (Australian Dollar/Canadian Dollar)

Exotic Pairs

Exotic pairs contain one major currency plus another from an emerging or relatively small economy, such as:

• USD/TRY (US Dollar/Turkish Lira)

• EUR/ZAR (Euro/South African Rand)

4.   How Currency Pairs Work in Forex Trading?

Currency pairs are exchanged on the Forex market; here, traders buy one currency and sell another. The cost of a currency pair depends on:

•  Economic performance of the respective countries

•  Supply and demand in the forex market

•  Global political events and market sentiment

Hence, these parameters cause exchange rate fluctuations which bring good chances for earning from trade by price movements.

5.   Forex Quotes: Bid Price, Ask Price & Spread

When trading in Forex, these two terms will be part of your vocabulary:

•  Bid Price: The price at which the trader sells the base currency.

•  Ask Price: The price at which the trader buys the base currency.

•  Spread: The Difference between these two indicates the profit of the broker.

Example

•  EUR/USD Bid: 1.1995 | Ask: 1.2000 | Spread: 5 pips

6.   What Drives Currency Movements

Economic Indicators

·       GDP Growth: Strong growth in the economy strengthens a currency.

·       Inflation Rates: A currency will lose value if inflation levels are high.

·       Interest Rates: High interest rates will draw investors and increase demand for that currency.

Political and Geopolitical Events

·       Elections, trade wars, and an unstable political environment all affect currency values.

Market Sentiment and Central Bank Policies:

·       What central banks changes in rates do is purport to stabilize the economy, whereas market sentiment is that the traders change their perception for demand of currency.

7.   Trading Currency Pairs: Strategies & Tips

Day Trading or Swing Trading:

·       Day Trading: Short-term trades that are usually closed within a day.

·       Swing Trading: Holding positions for a few days to capture medium-term trends.

Technical Analysis

·       Predicting market moves by utilizing charts, indicators, and price patterns.

·       Example: Indexes-Moving averages, RSI, Bollinger Bands.

Fundamental Analysis

·       Trading is based on news events, economic reports, and changes in policies.

Risk Management

·       Stop-loss orders for preventing excessive amounts of losses.

·       Take-profit orders for locking in profits.

·       Avoid over-leveraging due to increased exposure to a risk.

8.   Choosing Currency Pairs to Trade

·       Best for Beginners: Major pairs such as the EUR/USD and USD/JPY due to their stability and low spreads.

·       Volatile Pairs: Exotic pairs that tend to have a larger spread but a higher probability of profits.

·       Match Trading Style: Liquid pairs are the choice of a short-lived trader, whereas macroeconomic trends are analyzed by a long-term investor.

9.   Some Mistakes That Currency Traders Should Avoid

·       Over-leveraging: Increased risk and increased losses.

·       Neglecting both technical and fundamental analysis: Trading blindly is not a good idea.

·       Risk management: Not applying the methods of using stop-loss and take-profit can empty the trading account.

Conclusion and Final Thoughts

To comprehend currency pairs for forex trading is very important. In the essence of price movements, economics, and political events, the conclusion can be drawn.

Takeaway points that have to be remembered:

·       Currency pairs are categorized as major, minor, and exotic.

·       Forex trading consists of bid and ask prices along with spreads.

·       Economic indicators, market sentiment, and central bank policy are the driving forces for currency movement.

·       There would be technical and fundamental analysis along with risk management in any trading strategy.

Trading in the Forex market is a lifelong learning process intertwined with market analysis. Therefore, beginner should start their Forex trading journey with a demo account and not put in real capital unless confident. Happy Trading!