What are currencies, why do they come in pairs, and that pair types are there?
Let's start with the basics: Forex, or FX, is a foreign exchange market, where you are dealing in currencies. They usually are abbreviated and contain three letters. To help you recognize them without learning every single name by heart, generally, and this is true for many currencies, the first two letters represent the country name, the third letter – the currency name. For example, USD stands for United States dollar, GBP is Great Britain pound, etc.
When you first start learning about Forex trading, you'll see that currencies are traded in pairs: EUR/USD, AUD/CHF, NZD/JPY. When placing an order on Forex, you are buying one currency and selling another at the same time, i.e., if you pick the EUR/USD pair to purchase, you are buying euro and selling the dollar and vice versa.
What are base currency and quote currency?
The base and quote currencies are parts of the FX pair – that's it! Forex currency pairs have a very simple structure: the first one is the base currency, and the second one is the quote currency, also known as the counter currency. The price you see in the market is always the current Forex base currency value against the quote currency value. For example, if EUR/USD rate is around 1.22, one euro amounts to ~1.22 US dollars ($1 and 22¢).
In a pair, one currency will be stronger than the other, although the currency strength is not a constant and can change due to certain reasons, usually – important financial events in the region. This is why it makes sense to compare the currencies and value them against each other.
Types of pairs: majors, crosses, and exotic
Most popular Forex pairs, also known as majors or major pairs, take up most of the trades on the market:
As you can clearly see, all Forex major currency pairs include USD and another very common currency. Together these amount to about 75% of all trades – hence the name.
The popular currency pairs that are made up of major currencies other than the US dollar are usually called cross pairs. These include some of the most traded currencies, like EUR, GBP, JPY. Before trading these currencies was possible directly, they had to be converted through the American dollar, which meant you made two transactions and could sustain losses. Despite the fact that USD is still extremely popular on the market, the spread of Forex trading made cross pair trading more common and way more convenient.
Another category of FX currency pairs is exotic. As a general rule, one currency used here is a popular one like USD, and the other one – a rare currency, usually a currency of a developing or emerging economy. These could be Mexican peso or Brazilian real.
So, why should these categories be important to me?
These categories usually reflect the liquidity and volatility of the currency pairs.
Liquidity shows how interested other traders are in this particular pair. Basically, more popular pairs (e.g., major pairs) have higher liquidity. You can easily buy and sell EUR/USD in large quantities and don’t risk high variance.
Volatility is the price range of value within a certain period (day, week, month, etc.), meaning that it shows how stable the currency is. It depends on the number of orders with this particular currency on the market, economic well-being in the region, and certain macroeconomic events. Currencies with lower liquidity have higher volatility and vice versa. Normally, the less popular the pair (e.g., exotic pair), the higher its volatility. High volatility can be a risk for traders, although it is likely to bring a bigger profit: it all depends on your trading style and the strategies you use.
To be a better trader, you should always be aware of these aspects.