Forex is the world’s most traded market, boasting an average turnover in excess of US$4 trillion every single day. Strange to consider, then, that, despite the involvement of such large sums of money and so many people, the field remains beyond the comprehension of a significant proportion of the population.
One of the main issues is that people are not clear as to exactly how it works. They know that forex involves exchanging one currency for another, but the exact mechanics remain a mystery to them.
Essentially, forex works on the basis that one currency is bought as another is sold, with the intention of turning a profit. However, this cannot be understood without first comprehending the role, function and purpose of currency pairs.
How Forex Works
Understanding currency pairs is fundamental to understanding forex, yet many people looking to break into the market fail to fully comprehend how they work. With a field that is so intricate and technical, it’s perhaps unsurprising that the basics are often ignored in favor of explaining truly complex topics that people can’t teach themselves, such as technical analysis, candlesticks and indicators. Fledgling traders are often left to work the basics, such as currency pairs, out for themselves, which slows down the whole process of understanding the more complex issues. This is a serious mistake, as it is concepts like this that form the foundation of the market’s functionality.
So how do currency pairs work? Begin by considering the stock market. In this field, the tradable commodity is a company share, and profit is made through buying and selling these. You invest by paying for the stocks you want.
Trading a currency is not at all dissimilar. Commodities and currency function in the same manner, it is only that the commodity has become a currency in itself. However, essentially, you’re still paying to buy something – in this case, another currency. Also in the same vein as stock market trading, you sell one commodity against another – this time, a currency against a currency. This process creates currency pairs.
How Currency Pairs Work
Currency pairs as presented like this: EUR-USD or EUR-GBP. The order the currencies are formatted in is important, as it denotes which of them is the commodity (the first) and which is the money (the second). In both examples here, the euro is the commodity, and the money is American dollars and the pound respectively.
One area that often confuses people is that no matter the currency of your forex trading account, when you buy you pay in USD. This could mean, for example, that if you affected a EUR-USD trade, your trading account capital would be changed into USD, which would then be used to buy your euros. This is because American dollars are the main currency in the forex market, so they must act as the axis in all transactions, however impractical or roundabout this may seem. This is not something to concern yourself over, as these exchanges will be done automatically as you buy and sell.
Most brokers, like ThinkMarkets, will offer multiple currency pairs for you to choose from, and there is no right or wrong when it comes to making your selection. The important thing to bear in mind is purely how currency pairs work; once you understand that their values rise and fall against each other, and that it is this that you’re speculating on, you must choose your own path to success or failure – no magical combination can do it for you.