The Exchange Rate

The concept of buying and selling capital can be confusing because you're not buying anything in exchange for money, like you do in the stock market, for example. Instead you are simultaneously buying one currency and selling another.

In the stock market, traders buy and sell shares; in the futures market, traders buy and sell contracts; in the Forex market, traders buy and sell "lots". When you buy a currency lot, you are speculating on the value of one currency compared to another, on the exchange rate itself.

Currencies are traded in pairs. The pair is written in a particular format, best demonstrated by way of two examples. The Euro and the US Dollar:

EUR/USD

or the British Pound and the Japanese Yen:

GBP/JPY>

Every purchase of one currency implies a reciprocal sale of the other currency, and vice versa. This means that buying equals selling - curious isn't it? But the fact is that you are buying and selling the exchange rate, not a single currency.

The first member of every pair is known as the "base" currency, and the second member is called the "quote" or "counter" currency. The International Organization for Standardization (ISO) decides which currency is the base and which one is the quote within each pair.

The exchange rate shows how much the base currency is worth as measured against the counter currency. For example, if the USD/CHF rate equals 1.1440, then one US Dollar is worth 1.1440 Swiss francs. Remember, the value of the base currency is always quoted in the counter currency member within the pair (hence the name "quote currency"). A simple rule to understand the exchange rates would be to think of the base currency as one unit of that currency being worth the value of the exchange rate expressed in the quote currency.

Following the example above, one US Dollar is worth 1.1440 Swiss Francs.

Therefore, any unrealized profit or loss is always expressed in the quote currency. For example, when selling 1 US Dollar, we are simultaneously buying 1.1440 Swiss francs. Likewise, when buying 1 US Dollar, we are simultaneously selling 1.1440 Swiss francs.

We can also express this equivalence by inverting the USD/CHF exchange rate to derive the CHF/USD rate, that is:

CHF/USD = (1/1.1440) = 0.874

This means that the quote of one Swiss franc is 0.874 US Dollars. Note that CHF has now become the base currency and its value is accrued in USD.

In spot Forex, not all pairs have the US Dollar as the base currency. Primary exceptions to this rule are the British Pound, the Euro and the Australian and New Zealand Dollar.

GBP/USD, EUR/USD, AUD/USD, NZD/USD

When looking at a chart you can see if a currency pair, or in other words, the exchange rate between two currencies, is rising or falling.

In a free floating system, there are two main factors that can affect exchange rates every day: international trade (import/export of commodities, manufactured goods and services) and capital flows (following certain interest rates, equity performance, government debt instruments like bonds).

It is by buying and selling a currency, therefore exchanging it with other currencies, that it becomes stronger or weaker, independently from the fact that this transaction was speculative or not.

Currencies reflect the performance and policies of entire economies, sovereign governments and industry. It is the comparison of different currencies and their economies that drives exchange rates up and down.

Basically there are two main methods to estimate where a currency is heading: the fundamentals and price action.

The first refer to the economic and political factors that influence the value of currencies, such as the release of economical data and news. The second are graphical representations of the exchange rates like you see above. Graphs show offer and demand levels and price patterns which can be recognized visually. And as a numerical sequence, prices can be also technically analyzed using mathematical formulas.