Currency pairs are used because you are always selling one currency and buying the other. You sell the counter currency and buy the base currency. In a currency trade—assuming it is an investment or speculation and not being done for a simple transaction—when you take a long position, you are betting that the base currency will go up in terms of the counter currency. The currency pair is spelled out as the three-letter abbreviation for the base currency, then the abbreviation for the counter currency. There are several “major” currency pairs that are traded most often; foremost among those is USD/EUR. With USD/EUR, the U.S. dollar is the base currency and the euro is the counter currency. A quote of 0.8472, for example, means it takes 0.8472 euros to buy one dollar. The U.S. dollar is the base currency for most of the major currency pairs, including USD/JPY (Japanese yen as the quote currency), USD/CHF (Swiss franc), and USD/CAD (Canadian dollar).
How a Base Currency Works
When you trade currencies, you go long the base currency and short the other. Local shifts in interest rates, trade deficits, and economic growth can all be reasons to favor one currency over another. Trading is done on regulated exchanges called Forex (short for “foreign exchange”) and off-exchange markets. Currency pairs are quoted in incremental units called “pips.” A pip is the fourth digit after the decimal point in a quote, equal to .01% of one currency unit. If the quote is 0.8472, a move of one pip would change the quote to 0.8473 or 0.8471. Like stocks, currency pairs have bid-ask prices. The buyer pays the ask price and the seller gets the bid price. The market maker earns the spread, or difference between the two prices. Exchanges compete on spread prices to attract customers. Trades are done in “lots,” which are 100,000 units of the base currency. This may seem like a large minimum investment (and it is), but currency trading can have margin factors as low as 2% depending on the currency pair. That means if you trade one lot with dollars as the base currency, you only need $2,000 in the account to control $100,000 in the trade.
What It Means for Individual Investors
It’s imperative to understand the base currency when making any currency pair trades, not only because the base currency determines the direction of the trade (if you go long/buy the pair, you believe the base currency will go up relative to the quote currency), but also because of the size of the lot. For example, if you do a trade with the U.S. dollar as base currency, it is going to be based on a $100,000 lot size, whereas if you do a trade with a currency worth far more or less than the U.S. dollar, it could have a big impact on the margin requirement for your account.
