Forex is that market where buying and selling of currency pairs take place. Unlike the stock market, where you need to consider only one stock to analyze, in the forex market, you will have to examine two different currencies to trade one instrument, as instruments here are traded in pairs. Hence, the correlation between currencies plays a major role while trading a currency pair.
Understanding the Current Market Price (CMP)
The current market price (exchange rate) of a currency pair tells you the number of units of the quote currency you’re required to pay to buy one unit of the base currency. For example, let’s say the exchange rate of EURUSD is 1.1000. Here, to buy one unit of EUR, you will have to pay 1.1000 USD. So, basically, while trading a currency pair, you are buying one currency and simultaneously selling the other currency.
Extracting money from the Forex market
Our purpose in this market is to make money. And to make money (profit), understanding the relationship between the two currencies in a currency pair becomes vital. Now coming to the objective, a trader must buy a currency pair when they expect the base currency to have more potential to show strength in the future, comparative to the quote currency. Or in simple terms, to make a profit from a trade, you must go long on the currency pair when you think the base currency will increase in value relative to the quote currency. (Going ‘long’ in Forex is nothing but buying the currency pair and going ‘short’ is nothing but selling it)
Complete trade example
For instance, the CMP of USD/CAD as 1.3240. And let’s say you believe that the USD/CAD is going to drop in the near future. So, you wish to short sell this currency pair. Consider your short sold 10,000 units of USD/CAD. Here, by selling this pair, you have internally sold 10,000 US Dollars and bought the equivalent Canadian Dollars (10,000 USD * 1.3240 = 13,240 CAD). After some days, you see that the prices have dropped to 1.3180. Now, since the value of this currency pair has changed, the 10,000 US Dollars in CAD will be turn out to be, 10,000 USD * 1.3180 = 13,180 CAD. Now, when you sell this currency pair at the CMP, you will actually be buying 10,000 USD and selling 13,180 CAD.
In the above example, let us see if you made a profit or a loss. Initially, you had sold 10,000 USD to buy 13,240 CAD. At this point, you are sitting with 13,240 CAD. Later, you bought back that 10,000 USD, and you paid (sold) just 13,180 for it. That is, you are still left with 60 CAD (13,240 – 13,180) with you.
Hence, you made a profit of 60 CAD ( which is ~45 USD).
Quick cheat sheet
When you buy a currency pair (buy – base currency, sell – quote currency), you need the price of the currency pair to appreciate in value.
Conversely, when you sell a currency pair (sell – base currency, buy – quote currency), you need the price of the currency pair to depreciate in value.
Now let’s check if you understood the concepts right by answering the below questions.
When you short sell a currency pair, you have ______ the quote currency and ______ the base currency.
The current market price of a currency pair tells the number of units of quote currency that is to be paid to buy one unit of the base currency.
You know that GBP/JPY is going to increase in value in the near future. To make a profit from this pair, you have to buy the quote currency or sell the quote currency?
So let's say the CMP of GBP/JPY is 2. If it is increasing in value, that means the value of GBP appreciates, and JPY value depreciates. So if the value of JPY is depreciating in the near future, you should of course sell it to avoid losses.