When currencies are traded on the Forex market, they are traded in terms of “lot” sizes. Each lot is measured in units, with a standard lot being 100,000 units. For the purposes of this article, let’s assume we’re trading in Dollars. When trading through leverage, Forex traders can control $100,000 worth of currency with just one thousand dollars worth of investment capital. When trading Forex, currencies are bought and sold in currency pairs. Each currency in the pair is always denoted by 3 letters. Below is a list of the seven most commonly traded currencies:
- AUD: Australian Dollar
- CAD: Canadian Dollar
- CHF: Swiss Franc
- EUR: European Euro
- GBP: British Pound
- JPN: Japanese Yen
- USD: United States Dollar
When a Forex trader buys or sells a currency pair, he is actually doing both. For example: You own $100,000 USD, but you think that the value of the US Dollar will go down and you believe that the Australian dollar is going to rise. In this situation, you would buy $100,000 USD worth of Australian currency using your USD. In essence, you’re selling your USD to buy AUD. This is why currencies pairs are valued in terms of the exchange rate between the two currencies. When you see AUD/USD = 0.9845, it means that one Australian dollar is worth $0.9845 in US Dollars. The most common pairs are:
- EUR/USD (Euro & US Dollar) also known as the "Euro"
- USD/JPY (US Dollar & Japanese Yen) known as the "Dollar Yen"
- GBP/USD (British Pound & US Dollar) normally called "Cable"
- USD/CAD (US Dollar & Canadian Dollar) known as the "Dollar Canada"
- AUD/USD (Australian Dollar & US Dollar) also called the "Aussie Dollar"
- USD/CHF US (Dollar & Swiss Franc) referred to as the "Swissy"
- EUR/JPY (Euro & Japanese Yen) referred to as the "Euro Yen"
Therefore, when you buy the EUR/USD currency pair you are buying the Euro while selling the US dollar at the same time. When you sell this specific pair, you are selling the Euro and simultaneously buying the US Dollar. Your transaction will always be by the base currency in contrast to the counter currency.
To keep it simple, you can consider the currency pair as a single unit. It is perfectly normal to request a quote for a given currency pair by the base currency. Your Forex broker will be able to understand what you mean and you are still able to place trades through him. The distinction drawn between the two currencies is with regard to fundamental analysis concerns. The concept of the base and counter currencies is useful to demonstrate what is essentially happening in a Forex trade. In addition to purchases, you can also execute trades through short selling.
Short selling is the selling of an asset that the seller doesn't own, but promises to have delivered at a future time and at a certain price. Essentially, the broker who is assisting you in the short sell is lending you the asset. You sell the asset at the current level and hope that the value goes down. At some point, you will have to cover your loan and repurchase the asset (hopefully, at a lower price) to return to the broker. The difference between the price when you sold the asset, and that of your later repurchase, is your profit or loss. However, short selling in the equity market is controlled by the regulatory bodies. Whereas in the Forex market, because you are continuously buying the base currency and selling the counter currency, you are able to flip the transaction as to which will be the base currency and which will be the counter currency. The transaction is, essentially, the same and this permits you to short sell a currency pair without the restrictions found in the equity market. Because of short selling, you are able to profit from trading Forex regardless of how the market is moving.