Currency pairs play a crucial role in forex trading, as they serve as the foundation for traders to profit from fluctuations in exchange rates. In this article, we will delve into the concept of currency pairs, exploring their significance in the forex market.
We will specifically focus on major currency pairs, such as EUR/USD and GBP/USD. Furthermore, we will discuss the pros and cons of trading major currency pairs versus exotic currency pairs, highlighting the risks and potential rewards.
Currency Pairs – The Concept
To understand the concept of currency pairs, it is essential to grasp the basics of forex trading. Forex, short for Foreign Exchange, is the largest and most liquid financial market in the world, with a daily trading volume of over $5.3 trillion . It involves buying one currency while simultaneously selling another currency. The exchange rate between the two currencies determines the value of the trade. It is a way of comparing the value of one currency with another, which means the base currency against the quote currency. It shows how many units of quote currency are needed to buy base currency.
A currency pair represents the exchange rate between two currencies. Each currency pair consists of a base currency and a quote currency . The base currency is the currency being bought or sold, while the quote currency is the currency used to make the purchase. For example, in the currency pair EUR/USD, the euro is the base currency, and the US dollar is the quote currency.
In the forex market, a currency pair can be bought or sold as a unit. On purchasing a currency pair, you receive the base currency and sell the other one. Similarly, as a trader sells a currency pair, they sell the base currency and receive the second (quote) currency.
Currency pairs are meant to be compared against one another in order to understand how much of the quote currency is required to buy one unit of the base currency. Often, to identify each currency, there is a three-letter symbol associated with it. For instance, to represent the Canadian dollar in international markets, it is defined as “ CAD .”
Currency pairs are quoted based on their bid (buy) and ask prices (sell). The bid price is the price at which the forex broker will buy the base currency from you in exchange for the quote or counter currency. The ask—also called the offer —is the price at which the broker will sell you the base currency in exchange for the quote or counter currency.
Categories of Currency Pairs
Currency pairs are categorized into different types, such as major pairs , minor pairs , and exotic pairs .
Major Currency Pairs
The currencies that trade the most volume against the U.S. dollar are referred to as the major currencies. Major currency pairs are the most actively traded pairs and have the highest liquidity in the forex market.
According to Investopedia, they include:
- EUR/USD or the Euro vs. the U.S. dollar
- USD/JPY or dollar vs. the Japanese yen
- GBP/USD or the British pound vs. the dollar
- USD/CHF or the Swiss franc vs. the dollar
- AUD/USD or the Australian dollar vs. the U.S. dollar
- USD/CAD or the Canadian dollar vs. the U.S. dollar
These pairs are typically associated with the currencies of the world’s largest economies and are considered to be less risky due to their high liquidity and stable economic conditions. The final two currency pairs are known as commodity currencies because both Canada and Australia are rich in commodities and both countries are affected by their prices.
The EUR/USD Currency Pair
One of the most widely traded major currency pairs is the EUR/USD. The euro (EUR) represents the eurozone, which consists of 19 countries in Europe. The US dollar (USD) serves as the global reserve currency and is heavily influenced by the economic performance of the United States. The EUR/USD pair is known for its tight spreads and high liquidity, making it attractive to both short-term and long-term traders.
Historically, the EUR/USD pair has displayed a strong correlation with global economic trends. For instance, during the 2008 financial crisis, the pair experienced significant volatility as investors sought safe-haven assets, resulting in a sharp decline of the euro against the US dollar. Similarly, during periods of economic growth, the pair tends to appreciate due to increased investor confidence in the eurozone.
The GBP/USD Currency Pair
The GBP/USD pair, also known as the “cable,” represents the exchange rate between the British pound (GBP) and the US dollar (USD). It is influenced by various factors, such as economic data, political events, and monetary policy decisions. The pound is particularly sensitive to Brexit-related developments, as the ongoing negotiations between the UK and the European Union have a significant impact on the country’s economy and currency.
In recent years, the GBP/USD pair has experienced significant volatility due to the uncertainty surrounding Brexit. For example, following the UK’s decision to leave the EU in 2016, the pound depreciated sharply against the US dollar, reaching its lowest level in over three decades. This demonstrates how political events can have a profound impact on currency pairs.
Advantages and Disadvantages of Trading Major Pairs
Trading major currency pairs offer several advantages. Firstly, their high liquidity ensures that traders can enter and exit positions quickly, reducing the risk of slippage. Additionally, major pairs tend to have narrower spreads compared to exotic pairs since they are traded in large volumes, making them cost-effective for traders. Moreover, these pairs are often less volatile than exotic pairs, reducing the risk of sudden price fluctuations.
However, major currency pairs are not without their drawbacks. As they are heavily traded, they can be influenced by market manipulation, making it challenging to identify trends and patterns accurately. Furthermore, major pairs may exhibit lower profit margins compared to exotic pairs, as their price movements may be less pronounced. Traders need to carefully consider these factors when deciding on their trading strategy.
To illustrate the dynamics and challenges of trading currency pairs, let’s take a look at a real-life example. In early 2020, the COVID-19 pandemic caused significant disruptions to global markets, leading to increased volatility in currency pairs. The USD/JPY pair experienced a sharp decline due to investors flocking to safe-haven assets, driving up demand for the Japanese yen. This demonstrates how geopolitical events and crises can dramatically impact currency pairs and create trading opportunities.
Minor Currency Pairs
Simply put, minor currency pairs are those pairs that don’t include the U.S. dollar, but do include at least one of the world’s other three major currencies (Japanese yen, British pound, or the Euro). They are also known as cross-currency or “crosses”.
These pairs have slightly wider spreads and are not as liquid as the majors, but they are sufficiently liquid markets nonetheless. Depending on how volatile and liquid a market a trader wishes to invest in, he might find that the minor currency pairs are a safer investment than a major pair. As is the case with all other currency pairs, the rates can be influenced by several factors, including economic announcements, geopolitical events, and even global weather.
Popular minor pairs are:
- EUR/GBP – Euro vs. British Pound
- GBP/JPY – British Pound vs. Japanese Yen
- GBP/CHF – British Pound vs. Swiss Franc
- GBP/AUD – British Pound vs. Australian Dollar
- EUR/JPY – Euro vs. Japanese Yen
- AUD/CAD – Australian Dollar vs. Canadian Dollar
Exotic Currency Pairs
Exotic currency pairs, on the other hand, involve currencies from developing or emerging economies. These pairs are characterized by lower liquidity, wider spreads, and higher volatility.
Often when trading with exotic currencies, traders must be diligent and experienced in the field and account for destabilizing factors that affect currency value. In the case of exotic currencies, these factors can be the political or economic agenda of the country that increases volatility and triggers extreme movements or wild swings within the exotic trading pairs.
However, the idea of a common currency among the BRICS countries — Brazil, Russia, India, China, and South Africa — has raised questions about how it could affect forex trading. For forex traders, a BRICS common currency could mean reduced exchange rate volatility. With a common currency, the need to constantly monitor and react to exchange rate fluctuations between BRICS nations could decrease, making trading more stable and predictable… but this is an interesting topic for another article.
Examples of exotic pairs include USD/ZAR (US dollar/South African rand) and USD/TRY (US dollar/Turkish lira).
Trading exotic pairs can present lucrative opportunities for experienced traders due to their potential for large price swings. However, the risks associated with trading exotic pairs are higher, as the economic and political conditions of the countries involved can be unstable.
In conclusion, currency pairs are a fundamental concept in forex trading, serving as the basis for profiting from fluctuations in exchange rates. Major currency pairs, such as EUR/USD and GBP/USD, offer traders high liquidity, narrow spreads, and relatively stable economic conditions. However, they may be subject to market manipulation and exhibit lower profit margins.
Exotic currency pairs present higher risks and greater potential rewards due to their lower liquidity, wider spreads, and higher volatility.
Traders should carefully consider their trading strategy and risk tolerance when deciding on which currency pairs to trade. By staying informed about economic indicators, market trends, and geopolitical developments, traders can navigate the world of currency pairs effectively and maximize their chances of success in forex trading.