Part 2 - Learn Forex Trading: Currency Pair and Price

November 19, 2009 | scorpion

Previous: Part 1 - Learn Forex Trading: Forex Market Overview

Currency pairs are financial instruments traded in forex markets. Every pair of currency traded in the forex market is considered as an individual product (or financial instrument). A set of two currencies always constitute a currency pair, of which one currency is being bought by the other. The buying and selling of currencies from around the world constitute currency trading.

Currency Symbol

Each currency has its own symbol as for example:

For the Euro, it is EUR
For the Japanese, it is JPY
For the Pounds Sterling, it is GBP
For the Swiss Franc, it is CHF.

XXX/YYY is the general format by which currency pairs are denoted, where XXX and YYY both refer to the ISO 4217 international three-letter code of international currencies. Currencies are always traded in pairs, and here are a few examples of currency pairs:

For Euro-Dollar pair, it would be EUR/USD
For Pound Sterling-Dollar pair, it would be GBP/USD
For US Dollar-Canadian Dollar, it would be USD/CAD
For Australian dollar-US dollar, it would be AUD/USD

For Dollar-Swiss Franc pair it would be USD/CHF and so on for other currency pairs according to their three-letter currency codes. 80% of all trades in the Forex market originate from these currency pairs.

Consider this example of a currency pair GBP/USD. In this example of a currency pair, the currency on the left (GBP in this case) is called the base currency. The currency on the right (USD in this case) is called the quote currency (also called counter currency).The base currency (in this case GBP) always has a value of 1 in exchange rate.

In the currency pair GBP/USD, GBP is being bought, and the value of the currency on the right (USD in this case) represents how much of the base currency it is worth.

Consider another example of a currency pair EUR/USD 1.2436. This simply means 1 Euro is equal to 1.2436 US Dollars. Or it means that 1.2436 US dollars are needed to get one EUR. If you want to buy 100 Euros how much would you need in USD? You need precisely 124.36 US Dollars to buy 100 Euros.

Generally you will see the USD quoted first in most currency pairs the exceptions being Pounds Sterling, Euro- Dollar, Australian Dollar and New Zealand Dollar. The predominance of the US Dollar and the fact that it figures in a majority of forex transactions is perhaps a legacy of the Bretton Woods Agreement (1944), which pegged all currencies to the U.S. dollar.

“Bid” and “Ask” prices

All currency pair quotes have a bid and ask price. For example the currency quote for EUR/USD would appear as EUR/USD 1.4888/1.4890. The figure on the left, i.e. the number 1.4888 is called the “bid” price. This means you can sell 1 Euro for $1.4888

The number on the right of the currency quote EUR/USD 1.4888/1.4890, i.e. 1.4890 is called the “ask” price. This means you can buy 1 Euro for $1.4890. It is important to remember that the “bid” price is always lower than the “ask” price.

Spread

As we have seen from example cited above, every currency pair has a "bid" and "ask" price, and further the “bid” price is always lower than the “ask” price. The difference between the “bid” and “ask” price is called the “spread”.

In the currency example EURUSD 1.4888/1.4890 you will notice that there is a difference between the “bid” and the “ask” price. This difference is called as the spread. In other words, the “spread” is the difference between the highest price the buyer is willing to buy the currency and the lowest price the seller is willing to set it. For instance if you assume the “bid” price is $1 and the “ask” price is $1.3 then the spread would be $0.3.

In the example of currency quote EUR/USD 1.4888/1.4890 we discussed earlier, you will notice that the spread is 2 pips being the difference between the ask price and the bid price (1.4890 minus 1.4888). “Spreads” are usually on the lower side in forex markets on account of high liquidity

What is a pip?

Pip, is an acronym for Price Interest Point, and represents the smallest digit in the price of a currency. Pip is also the method by which profit is calculated in a currency deal, and its value depends on the base currency of the pair. Consider this example. A move in the EUR/USD from 1.4877 to 1.4897 equals 20 pips. And a move in the USD/JPY from 89.70 to 89.90 equals 20 pips.

When your trading account is in US Dollars and the U.S. dollar is the base currency, then one pip equals one dollar in a mini account or ten dollars in a standard account. So if you place a trade with one of these currencies and earn 20 pips it would translate to a profit of $20 in a mini account or $200 in a standard one.

If the base currency is not the U.S. dollar, then the value of one pip is equal to one unit of the base currency. For example in the GBP/USD, the pound sterling is the base currency, so one pip is equal to one pound; So if you make 20 pip profits in GBP/USD it would mean a profit of 20 pounds Sterling in a mini account. When you make profits in these currencies, you’re making them in the base currency, which then may be exchanged into the U.S. dollar at the current exchange rate, since your trading account may not be denominated in the base currency.

Summing up, in this article we have learnt what a currency pair is, and what is meant by “bid” and “ask” prices, spread and pip.

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