One of the biggest sources of confusion for those new to the currency
market is the standard for quoting currencies. In this section, we'll go
over currency quotations and how they work in currency pair trades.
Reading a Quote
When
a currency is quoted, it is done in relation to another currency, so
that the value of one is reflected through the value of another.
Therefore, if you are trying to determine the exchange rate between the
U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look
like this:
This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S.
dollar) is always equal to one unit (in this case, US$1), and the
quoted currency (in this case, the Japanese yen) is what that one base
unit is equivalent to in the other currency. The quote means that US$1 =
119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen.
The forex quote includes the currency abbreviations for the currencies
in question.
Direct Currency Quote vs. Indirect Currency Quote There are two ways to quote a currency pair, either directly or indirectly.
A direct currencyquote is simply a currency pair in which the domestic
currency is the base currency; while an indirect quote, is a currency
pair where the domestic currency is the quoted currency. So if you were
looking at the Canadian dollar as the domestic currency and U.S. dollar
as the foreign currency, a direct quote would be CAD/USD, while an
indirect quote would be USD/CAD. The direct quote varies the foreign
currency, and the quoted, or domestic currency, remains fixed at one
unit. In the indirect quote, on the other hand, the domestic currency is
variable and the foreign currency is fixed at one unit.
For example, if Canada
is the domestic currency, a direct quote would be 0.85 CAD/USD, which
means with C$1, you can purchase US$0.85. The indirect quote for this
would be the inverse (1/0.85), which is 1.18 USD/CAD and means that
USD$1 will purchase C$1.18.
In the forex spot market, most
currencies are traded against the U.S. dollar, and the U.S. dollar is
frequently the base currency in the currency pair. In these cases, it is
called a direct quote. This would apply to the above USD/JPY currency
pair, which indicates that US$1 is equal to 119.50 Japanese yen.
However,
not all currencies have the U.S. dollar as the base. The Queen's
currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand
dollar - are all quoted as the base currency against the U.S. dollar.
The euro, which is relatively new, is quoted the same way as well. In
these cases, the U.S. dollar is the counter currency, and the exchange
rate is referred to as an indirect quote. This is why the EUR/USD quote
is given as 1.25, for example, because it means that one euro is the
equivalent of 1.25 U.S. dollars.
Most currency exchange rates
are quoted out to four digits after the decimal place, with the
exception of the Japanese yen (JPY), which is quoted out to two decimal
places.
Cross Currency When a currency quote is given without the U.S. dollar as one of its components, this is called a cross currency.
The most common cross currency pairs are the EUR/GBP, EUR/CHF and
EUR/JPY. These currency pairs expand the trading possibilities in the
forex market, but it is important to note that they do not have as much
of a following (for example, not as actively traded) as pairs that
include the U.S. dollar, which also are called the majors.
Bid and Ask As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long),
the ask price refers to the amount of quoted currency that has to be
paid in order to buy one unit of the base currency, or how much the
market will sell one unit of the base currency for in relation to the
quoted currency.
The bid price is used when selling a currency pair (going short)
and reflects how much of the quoted currency will be obtained when
selling one unit of the base currency, or how much the market will pay
for the quoted currency in relation to the base currency.
The
quote before the slash is the bid price, and the two digits after the
slash represent the ask price (only the last two digits of the full
price are typically quoted). Note that the bid price is always smaller
than the ask price. Let's look at an example:
USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005 |
If you want to buy this currency pair, this means that you intend to
buy the base currency and are therefore looking at the ask price to see
how much (in Canadian dollars) the market will charge for U.S. dollars.
According to the ask price, you can buy one U.S. dollar with 1.2005
Canadian dollars.
However, in order to sell this currency pair,
or sell the base currency in exchange for the quoted currency, you would
look at the bid price. It tells you that the market will buy US$1 base
currency (you will be selling the market the base currency) for a price
equivalent to 1.2000 Canadian dollars, which is the quoted currency.
Whichever
currency is quoted first (the base currency) is always the one in which
the transaction is being conducted. You either buy or sell the base
currency. Depending on what currency you want to use to buy or sell the
base with, you refer to the corresponding currency pair spot exchange rate to determine the price.
Spreads and Pips The
difference between the bid price and the ask price is called a spread.
If we were to look at the following quote: EUR/USD = 1.2500/03, the
spread would be 0.0003 or 3 pips,
also known as points. Although these movements may seem insignificant,
even the smallest point change can result in thousands of dollars being
made or lost due to leverage. Again, this is one of the reasons that speculators are so attracted to the forex market; even the tiniest price movement can result in huge profit.
The
pip is the smallest amount a price can move in any currency quote. In
the case of the U.S. dollar, euro, British pound or Swiss franc, one pip
would be 0.0001. With the Japanese yen, one pip would be 0.01, because
this currency is quoted to two decimal places. So, in a forex quote of
USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade
within a range of 100 to 150 pips a day.
| Currency Quote Overview |
| USD/CAD = 1.2232/37 |
| Base Currency |
Currency to the left (USD) |
|
| Quote/Counter Currency |
Currency to the right (CAD) |
| Bid Price |
1.2232 |
Price for which the market maker will buy the base currency. Bid is always smaller than ask. |
| Ask Price |
1.2237 |
Price for which the market maker will sell the base currency. |
| Pip |
One point move, in USD/CAD it is .0001 and 1 point change would be from 1.2231 to 1.2232 |
The pip/point is the smallest movement a price can make. |
| Spread |
Spread in this case is 5 pips/points; difference between bid and ask price (1.2237-1.2232). |
Currency Pairs in the Forwards and Futures Markets One
of the key technical differences between the forex markets is the way
currencies are quoted. In the forwards or futures markets, foreign
exchange always is quoted against the U.S. dollar. This means that
pricing is done in terms of how many U.S. dollars are needed to buy one
unit of the other currency. Remember that in the spot market some
currencies are quoted against the U.S. dollar, while for others, the
U.S. dollar is being quoted against them. As such, the forwards/futures
market and the spot market quotes will not always be parallel one
another.
For example, in the spot market, the British pound is
quoted against the U.S. dollar as GBP/USD. This is the same way it would
be quoted in the forwards and futures markets. Thus, when the British
pound strengthens against the U.S. dollar in the spot market, it will
also rise in the forwards and futures markets.
On the other
hand, when looking at the exchange rate for the U.S. dollar and the
Japanese yen, the former is quoted against the latter. In the spot
market, the quote would be 115 for example, which means that one U.S.
dollar would buy 115 Japanese yen. In the futures market, it would be
quoted as (1/115) or .0087, which means that 1 Japanese yen would buy
.0087 U.S. dollars. As such, a rise in the USD/JPY spot rate would
equate to a decline in the JPY futures rate because the U.S. dollar
would have strengthened against the Japanese yen and therefore one
Japanese yen would buy less U.S. dollars.
Now that you know a
little bit about how currencies are quoted, let's move on to the
benefits and risks involved with trading forex.
