How do Currency Pairs Work in The Forex Market?
People are often confused as to how currency pairs work in the forex market? And it is a valid question as in the cash forex market you are purely speculating on the change in value of the currency pair you are trading. You are not actually taking delivery of any sum of money. For example. If you buy EUR/USD you are buying Euros in exchange for U.S Dollars. You aren’t going to get a lump sum delivery of Euro currency at the front door.
One of the original purposes of the forex market was to facilitate the exchange of one currency for another. This would commonly be used for the purpose of multinational corporations that need to trade currencies continually, for example an American company may regularly buy in goods from Germany and doesn’t want to be at the mercy of the fluctuating exchange rate for Euros. So will trade Euros in the forex market to hedge this exposure at a favorable price. To illustrate this example further say Company A in America knows it buys in approximately 1 million dollars worth of goods from Germany each year (which will be priced in Euros) and the current exchange rate is at a historic low ( the value of the dollar is very high relative to the Euro meaning exchange rates are favorable) Company A can execute a forex transaction that locks in this price.
However, only about 20% of the market volume is trades conducted for this reason. Around 80% of trades in the currency market are speculative in nature, put on by large financial institutions and even individuals who want to express their opinions on the economic and geopolitical events of the day.
Currencies always trade in pairs, so this means that when a trader makes a trade he or she is always buying one currency and selling the other. If you go into a shop you buy a product in exchange for dollars. Well in the foreign exchange market that product can be Euros, or British Pounds or any other currency you fancy.
Once this transaction is made you have an open position and your account will start moving to reflect the gain or loss your account should you reverse that transaction. So to use a simple example. If you buy $1000 of euros you have bought euros sold dollars. If the price of the euro rises 10% you can reverse that transaction and buy back your dollars and sell your euros at a price 10% higher and you have made $100. There was never any transaction of physical cash, it is all reflected in your brokerage account.
If this isnt clear, or you want any other forex trading related question answered feel free to check our Forex FAQ’s section