The nuts and bolts of currency pairs

Although it may seem redundant to even mention, there are two currencies graphed into each forex currency pair chart. This is the major difference between trading currencies, and trading any other financial security: stocks, commodities, and everything else are graphed strictly against themselves, but currencies are graphed against each other.

This little fact makes no difference when it comes to technical analysis. Chart patterns, indicators, trend lines, and the like function the same on any charted security. But for fundamental analysts, it can make a difference.

The major currencies traded via online trading platforms are:
•    U.S. dollar (USD, greenback, or buck)
•    Euro (EUR or single currency)
•    U.K. pound sterling (GBP or cable)
•    Japanese yen (JPY)
•    Swiss franc (CHF or Swissie)
•    Canadian dollar (CAD or loonie)
•    Australian dollar (AUD or Aussie)
•    New Zealand dollar (NZD or kiwi)

Some trading platforms also permit transactions with gold and silver, as well as some of the popular but less frequently traded currencies, such as the Mexican peso and Swedish krona.

The first currency mentioned in a currency pair is called the base currency; the second is the cross or counter currency. The pairs traded in the international forex trading market have been standardised by the International Organisation for Standardisation (ISO) and should be used consistently by traders to avoid confusion.

Note the chart below:

This is the daily chart of the Euro versus the Australian dollar, currency pair EUR/AUD. During the time frame shown, the Australian economy has benefited from a mining and commodities boom that has forced the Reserve Bank to initiate tighter monetary policy and raise the overnight cash rate.

Europe, on the other hand, has suffered from a financial crisis revolving about Greece’s sovereign debt and potential default. While the European economy has exited recession, the recovery is nowhere near stout enough for higher interest rates and may not be until sometime next year.

In such a scenario, it’s no wonder the Euro has fallen so dramatically against the “Aussie.” Capital flows from lower interest rates to higher ones, from weak economies to strong ones, as the chart above graphically illustrates.

Each currency pair is priced in terms of the cross currency. At the starting point on the chart above, 1 December 2009, the Euro was worth roughly $1.64 in Australian terms. At the ending point, 23 April 2010, it was worth $1.44. Traders who shorted EUR/AUD would have earned 2,000 pips at $10 Australian currency per pip for a standard account, or $1 Australian for a “mini” account which trades partial lots.

Most of the time, currency pair movements aren’t so one-sided. The chart below is a more common sight:

This daily chart of EUR/GBP shows a currency pair that’s range-bound, or trading roughly sideways between wide margins. Although careful traders could earn similar returns with this currency pair, it would require more work than the strong trend displayed by EUR/AUD.