In any financial market, what is actually being traded is naturally the most important thing in that market. This is otherwise known as a financial instrument; these instruments are the subject of trading in such markets. In the case of the foreign exchange market or forex, the financial instruments for trading are the currencies themselves, naturally. But these are not standalone currencies that are traded. In fact, in the forex market, traders deal with pairs of currencies, or currency pairs for trading. In this article we are going to delve deep into understanding currency pairs, how they work, and how you can choose the best one to trade.
Currency Pairs: Beginning with Definitions
First off, we need to begin with the basic definitions. What is a currency pair after all? As the name suggests, a currency pair is made of two currencies – hence a pair. The reason we deal with pairs in the forex market and no single currencies is that we do not actually trade single currencies. Rather the forex market is a speculation market, where traders speculate on the value of currencies against other currencies. This is exactly why we need to have two currencies to create a financial instrument in this market.
But what is the relationship between these two currencies in a pair? The relationship between two currencies is directly related to price speculation. We speculate the price of one currency against another. So imagine the popular trading pair EUR/USD. As you can guess, this pair is made from the two currencies of Euro and the US Dollar.
There is also a reason why a currency comes first and another second. The first currency is known as the base currency and the second one is called the quote currency. Basically, we speculate the price of base currency against the quote currency. In other words, we want to see how much quote currency is needed to purchase one unit of the base currency.
For example, if we consider the price of EUR/USD to be 1.01 this means to purchase 1 Euro we would need 1.01 USD. The same goes for all the other currency pairs.
What Are the Different Types of Currency Pairs?
To choose the best currency pair to trade, you need to be familiar with all the different types of pairs that exist in the forex market. All in all, there are three main types of pairs in the forex market:
- Major currency pairs
- Minor currency pairs
- Exotic currency pairs
Major currency pairs are those that always have the US Dollar as one of the currencies in the pair. So all the following pairs can be considered as major currency pairs: EUR/USD – GBP/USD – USD/JPY
Minor currency pairs are those that do not include the US Dollar, but they still have the major currencies in them. The following can be considered as minor currency pairs: EUR/GBP – GBP/JPY
Exotic currency pairs are by nature rather exotic. It means they are made of one currency from a lesser known economy or a developing country in addition to a major currency such as the US Dollar. The following can be regarded as exotic currencies: USD/TRY (Turkish Lira) – EUR/ZAR (South African Rand)
How Can You Choose the Best Pair to Trade?
Now that you are familiar with the notion of currency pairs and also the different types of pairs, let’s see what factors you ought to consider in order to pick the best pair to trade.
To pick any currency to trade, you need to consider the four following factors:
- Liquidity
How liquid a currency is refers to how easily it can be purchased or sold in the market without having to impact its value in that market. Major currencies such as EUR/USD are so powerful and liquid that, first, they can be bought and sold quickly, and second, you will not experience any noticeable price slippage when you place an order to buy or sell. On the other hand, less known currencies and exotic pairs are less liquid and when you attempt to trade them, you might want to watch out for price slippage.
- Volatility
Simply put, volatility means the amount of price change a currency goes through. Naturally when a currency is powerful, it experiences less volatility. On the other hand, when we are dealing with less powerful currencies, such as those in exotic pairs, their price can fluctuate more easily and thus they are more volatile. While a higher volatility can be the grounds for higher profits margins, it also means there are higher risk factors involved.
- Session
Forex sessions can have a huge impact on the liquidity of currency pairs. For instance, pairs such as EUR/USD are naturally more liquid during the London session or the New York session. But it is incredibly more liquid when these two sessions overlap.
- Economy
Another factor that you need to consider in order to evaluate the strength of a currency is the economy behind it. The strength of the economy is directly tied to the strength of the currency as well. Naturally the US economy with a high GDP will have a much more powerful currency, i.e. the US Dollar, compared with the Zimbabwean Dollar, with an extremely weak economy.
A List of Ideal Pairs for Different Traders to Trade
Picking the best currency pair to trade will ultimately boil down to the level of expertise and skill that you have as a trader. The following is a ballpark evaluation of the difficulty of trading for pairs and the correspondent traders who will be ideal for trading them.
- Low level of difficulty
For beginner traders who do not have a lot of experience trading currencies in the forex market, the best idea perhaps would be to trade the major currency pairs, such as EUR/USD, GBP/USD, and USD/JPY. The reason major currency pairs have a lower level of difficulty for novice traders is that such currencies are much more liquid and they are also much less volatile. So a high liquidity and a low volatility mean they are more reliable for trading.
- Medium level of difficulty
If traders have a bit higher experience trading currencies, they can opt for minor currency pairs, such as EUR/GBP or AUD/JPY. These pairs have a slightly less level of liquidity and also a higher level of volatility compared with major currency pairs. Therefore, they behave much less reliably in the market and would require a more experienced hand to trade them.
- High level of difficulty
For those traders who want to take it up a notch, they can refer to exotic pairs. These currency pairs have the lowest level of liquidity and also the highest level of volatility. Therefore, it would require a significantly high degree of experience and skill to be able to trade them.
