Lesson 2: What Do Traders Trade in Forex?

Currencies.

That's what you trade in the forex market. Or, more specifically, currency pairs.

Foreign exchange (Forex) trading lets you take advantage of the currency exchange rate movement between currency pairs. If you think that one currency is worth more than the other today, you can trade forex to make a profit. 

There are more than 180 legally recognized currencies you can pair together. Your decisions on choosing a pair should always be based on your strategy. 

Lesson Highlights  

• Currencies are your assets when trading in the forex market, and they always come in pairs called currency pairs.  
• All currency pairs have two components: base currency and quote currency. 
• Exchange rate systems (fixed and floating rates) can tell you the potential price movement of a currency.  
• You can choose from three currency pair categories: major, minor, and exotic.  
• Major currency pairs are always paired with the U.S. dollar. The pair's other half includes one of the seven other major currencies.
• Minor currency pairs do not include the USD; instead, they are pairings of two non-USD major currencies.  
• Exotic currency pairs are any currency pairs that include a major currency and a currency from an emerging market. 

Overview: Forex Market 

You’re simultaneously buying one currency and selling another when you’re in the forex market. Basically, you'll gain profit when the value of your base currency goes up because the exchange rate between the two will spread. 

The difference between the exchange rate when you open and close a trade determines whether you profit from your trade.

Note: You can see the price of the forex pair by looking at how much quote currency you need when you for the base currency. Assuming the price of USD/JPY is 144, then it means that USD 1 equals JPY 144 .

Currency pairs 

When trading forex, you never use a singular currency. You should always choose currency pairs that maximize the exchange rate value between the paired currencies, which results in a profit gained.  

Say you buy a pair, the USD/JPY. 

In this case, you're rooting for the USD to strengthen against the JPY. You can then sell it when the USD weakens against the JPY.

Currency pairs have two components: a base currency and a quote currency. 

1. Base Currency: The first listed currency in the pair (e.g., USD). This currency can be the one you're selling or the one you're buying.  
2. Quote Currency: The second stated currency in the pair (e.g., JPY). This currency is the one that you receive or the one you sell.  

When you sell a currency pair, you’re selling the base currency and receiving the quote currency. Meanwhile, when you buy a currency pair, you buy the base currency and then sell the quote currency.  

Currency Exchange Rate Systems: Fixed Float vs. Free Float 

You can determine the potential movement of currency value using two different methods: a floating rate system and a fixed rate system.   

Learning these currency exchange rate systems is beneficial in strategizing a trade. It could help you determine the currency pair's value and predict the possible exchange rate movements.  

1. Fixed Rate 

A fixed exchange rate system indicates that the currency pair will always have the same value or price regardless of market changes.  

It follows the official exchange rate set by its issuing government or central bank. A country's central bank can keep its currency's value within its target zone by buying and selling currencies in the forex market.  

Basically, the government or the central bank intervenes and manipulates its currency prices to keep it favorable for international forex trading.  

2. Floating Rate  

In a floating exchange rate system, the open or private markets determine currency pair values. 

The currency value changes depending on market factors, primarily the supply and demand of the currency.  

If the demand for a currency is high, its value will increase. Conversely, if the demand is low, the currency's value will decrease.  

Major Currency 

Major currencies belong to some of the strongest and most stable economies worldwide. Their stability makes them the most heavily traded and most liquid currencies in the forex market.  

If you're new to the forex market, it's best to start trading with major currencies.  

However, classifying currencies as major is somehow subjective. But there will always be staple currencies to the major currency classification. 

In the forex market, the most traded major currency pair is the EUR/USD. The main reason for this is the economic status of both the United States and the Eurozone.  

Both regions have immense influence on the global stage. This means traders can easily monitor the two regions' economic indicators when developing trading strategies. 

Aside from the political and economic clout of the US and the EU, there are other factors that contribute to popularity of the EUR/USD pair. These factors include the high liquidity, volatility, and established historical prices of these currencies, as well as the diverse market participants that trade them.

Note: Major currency pairs must always be paired with the U.S. dollar because of the currency's strong economic status. It is a stable benchmark to trade with other major currencies. 

Minor Currency 

Unlike their major counterparts, minor currencies are not paired with the U.S. dollar. Instead, non-USD major currencies are traded against one another.

These pairs are in the popular spectrum in the forex market. However, they are less in demand than the major pairs, resulting in bigger price swings.  

Examples of popular minor currency pairs are:

1. EUR/GBP
2. EUR/AUD
3. GBP/JPY
4. CHF/JPY
5. NZD/JPY 
6. AUD/JPY
7. GBP/AUD
8. GBP/CAD
9. CAD/JPY
10. NZD/JPY 

Exotic Currency 

Exotic currencies are from emerging markets that are becoming engaged in the global financial scene.  

Technically, an emerging market is transitioning into a developed market economy. There are numerous factors that point out exotic currencies, but these are the most significant:

1. The currency experienced strong economic growth.  
2. The currency has a liquid debt and equity market. 
3. The currency can be accessed by foreign investors. 
4. The currency has a developed and reliable regulatory system. 

Trading exotic currencies opens you to unique, profitable opportunities and portfolio diversification. However, these currencies are among the least traded in the forex market. It's less liquid and sees little movement in forex trading activities.  

Exotic currency pairs always include one major currency and an exotic currency.  

In the next lesson, you'll learn more about forex and the nitty-gritty of buying and selling currency pairs.