Currencies are always trade in pairs, when a trader makes a trade he or she is always long/buying one currency and short/selling the other.
If a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, they would have exchanged euros for dollars and would now be “short” euros and “long” dollars. To better understand this dynamic, let’s use an exact example. If you went into a computer store and purchased a laptop for $1,000, what would you be doing?
You would be exchanging your dollars for a computer. You would basically be “short” $1,000 and “long” one computer. The store would be “long” $1,000 but now “short” one computer in its inventory. The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.
Now let’s get a bit more specific about why you need to purchase currencies in pairs. Since you can’t buy a physical asset on the Forex Exchange, you need to trade against another currency. Also the value of a currency is only in relationship to a specific currency. If you were sure that the USD was going to move up today, would it be moving up against all currencies or against a specific currency. It might move up against the Euro, but the Japanese Yen might be strong today so the dollar falls against the Yen, so you have to select the currency that you wish to hedge pair with. You can simply buy dollars and hold them, but at some point you will have to do something with them, but you have dollars so why would you use those dollars to buy more dollars. If you wish to buy the Australian Dollar, you would have to use your US Dollar to make the purchase so you are pairing USD/ANZ. You would not buy the Australian Dollar if you thought it was going to go down tomorrow in value, you would wait till tomorrow where you could get move Australia Dollars for your US Dollars. Now you have it. That is the Forex Market.
Let’s give you another easy to follow scenario.
You are going to London on vacation. From London you are going to France. The UK currency is known as Sterling or the Great British Pound, GBP and France is part of the Euro. If you called and booked your hotel today and they required payment in advance in their local currency. What would you do?
The agent in the UK told you that you needed to wire them 1000gbp and you checked with your bank and they told you that it was equal to 1600.00USD today and the agent in France said you needed to send them 1000euros and your bank told you that that was 1300.00. You heard on the news that the Euro was falling quickly because of economic problems in Europe, would you pay the bill today, or would you wait a few days and check with your bank again. When you do, you might find that 1000euros would only cost you 1250.00, you save or made 50.00, but at the same time they might just tell you that the 1000gbp would not cost you 1700.00 you lost 100.00. This is because currencies move in different relationships to other currencies.
We will discuss currency pairs again in another article, so keep your eyes out of our next article. Remember to make money in the forex markets; education and knowledge is the key.