Each currency pair represents the current exchange rate for the two currencies. Here’s how to interpret that information, using EUR/USD—or the euro-to-dollar exchange rate—as an example:
The currency on the left (the euro) is the base currency.
The currency on the right (the U.S. dollar) is the quote currency.
The exchange rate represents how much of the quote currency is needed to buy 1 unit of the base currency. As a result, the base currency is always expressed as 1 unit while the quote currency varies based on the current market and how much is needed to buy 1 unit of the base currency.
If the EUR/USD exchange rate is 1.2, that means €1 will buy $1.20 (or, put another way, it will cost $1.20 to buy €1).
When the exchange rate rises, that means the base currency has risen in value relative to the quote currency (because €1 will buy more U.S. dollars) and conversely, if the exchange rate falls, that means the base currency has fallen in value.
A quick note: Currency pairs are usually presented with the base currency first and the quote currency second, though there’s historical convention for how some currency pairs are expressed. For example, USD to EUR conversions are listed as EUR/USD, but not USD/EUR.
Three Ways to Trade Forex
Most forex traders aren’t made for the purpose of exchanging currencies (as you might at a currency exchange while traveling) but rather to speculate about future price movements, much like you would with stock trading. Similar to stock traders, forex traders are attempting to buy currencies whose values they think will increase relative to other currencies or get rid of currencies whose purchasing power they anticipate will decrease.
There are three different ways to trade forex, which will accommodate traders with varying goals:
The spot market. This is the primary forex market where those currency pairs are swapped and exchange rates are determined in real-time, based on supply and demand.
The forward market. Instead of executing a trade now, forex traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed-upon amount of currency on a future date.
The futures market. Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.
The forward and futures markets are primarily used by forex traders who want to speculate or hedge against future price changes in a currency. The exchange rates in these markets are based on what’s happening in the spot market, which is the largest of the forex markets and is where a majority of forex trades are executed.
Forex Terms to Know
Each market has its own language. These are words to know before engaging in forex trading:
Currency pair. All forex trades involve a currency pair. In addition to the majors, there also are less common trades (like exotics, which are currencies of developing countries).
Pip. Short for percentage in points, a pip refers to the smallest possible price change within a currency pair. Because forex prices are quoted out to at least four decimal places, a pip is equal to 0.0001.
Bid-ask spread. As with other assets (like stocks), exchange rates are determined by the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers require to sell (the ask). The difference between these two amounts, and the value trades ultimately will get executed at, is the bid-ask spread.
Lot. Forex is traded by what’s known as a lot, or a standardized unit of currency. The typical lot size is 100,000 units of currency, though there are micro (1,000) and mini (10,000) lots available for trading, too.
Leverage. Because of those large lot sizes, some traders may not be willing to put up so much money to execute a trade. Leverage, another term for borrowing money, allows traders to participate in the forex market without the amount of money otherwise required.
Margin. Trading with leverage isn’t free, however. Traders must put down some money upfront as a deposit—or what’s known as margin.
What Moves the Forex Market
Like any other market, currency prices are set by the supply and demand of sellers and buyers. However, there are other macro forces at play in this market. Demand for particular currencies can also be influenced by interest rates, central bank policy, the pace of economic growth, and the political environment in the country in question.
The forex market is open 24 hours a day, five days a week, which gives traders in this market the opportunity to react to the news that might not affect the stock market until much later. Because so much of currency trading focuses on speculation or hedging, it’s important for traders to be up to speed on the dynamics that could cause sharp spikes in currencies.