How Forex Pairs Work & Which to Trade?

Forex trading effectively involves the exchange of one currency for another.

So there are by definition two components (or a pair of currencies) in every trade.

The term Forex pair simply reflects this duality. Forex rates (the prices of Forex pairs) move continuously, as they respond to new information and drivers, alongside changes in investor sentiment and the natural ebb and flow of supply and demand that is common to any marketplace.

Balancing Act

If investor sentiment around a particular currency is positive, then that positivity can create additional demand (buyers) for the currency. If that extra demand outweighs the available supply of that currency, then the price, which sellers demand to part with the currency, will rise. Conversely if new information emerges that creates negative sentiment around a currency, demand for that currency may fall. Whilst the supply (the number of sellers) will rise. In these circumstances buyers will reduce the amount they are prepaid to pay to own the currency or withdraw their bids and the price of that currency will fall.

Of course as we established above, in Forex trading the value of a given currency is reflected in changes to the relative value of that currency, against a counterpart or pair.

Nature of a Forex Pair

Let’s take a closer look at what these changes mean practically and how a Forex pair works and what it represents in practise. So what do we mean when we say that the value of one currency is measured by the change in its relative value in another currency. Well that is simply how Forex pairs work, or indeed what they are for.

The exchange rate between the British Pound Sterling and the US Dollar reflects the relative values of each currency, compared to the other, at a given moment in time. if you want to think about that in a different way then think of it like this: The exchange rate reflects the amount of goods and services that a unit of currency A will buy you in currency B.

So at an exchange rate of US$ 2.00 to the Pound, a seller of a single Pound Sterling would be able to buy US$2.00 worth of goods and services in the USA. At an exchange rate of US$1.20 however, the amount of goods and services a seller of a lone Pound Sterling could buy, in the USA, falls to US$1.20, a 40% reduction. Of course the inverse or opposite is true for a seller of a single US Dollar buying goods and services in the UK in Pounds Sterling.

This constantly changing relationship is expressed by the Currency or Forex pair known as “Cable”. After the transatlantic telegraph cables that first transmitted exchange rates in the late nineteenth century, between London and New York .

The Matrix

As we have noted already changes in sentiment, supply and demand, or the emergence of new information about a currency and its underlying economy, can and will affect its value, relative to other currencies. These changes in value do not happen in isolation however.
But rather they take place within a matrix of Forex Pairs and Crosses (Crosses are classically considered to be those exchange rates which do not contain the US Dollar and or more recently the Euro as a constituent).

So that a change in the value of the GBP USD pair (Great British Pound US Dollar) is also likely be reflected in the value of the GBP JPY cross (Great British Pound Japanese Yen), the USD JPY Pair (US Dollar Japanese Yen) and the EUR USD pair (Euro US Dollar exchange rate) and so on and so on. In fact if the changes in value are significant enough, they will have a ripple effect across the values of all Forex Pairs and Crosses, no matter how far removed they are from the original currencies.

Note that all Forex pairs and crosses are denoted by a specific code or Mnemonic. Which combines the three letter “ISO 427” code for each individual currency. This is the bold annotation we have used in the examples immediately above

Variable Nature

The scale of any movement in the price of other Forex pairs and crosses will depend on a variety of factors and variables, which include interest rate differentials (both now and in the future), economic performance, as well the nature of their underlying economies plus many more.

The sensitivity to and likely direction of these corresponding moves is denoted within a measurement known as correlation. A statistical calculation that is expressed as a percentage or ratio,which in the case of Forex can have either positive or negative values.

A high positive correlation between two Forex pairs suggests that change in the value of Forex pair A, will be reflected by a move in the same direction, in the value of Forex pair B.

Whilst a strong negative correlation between two FX pairs or crosses implies that change in the value Forex pair C will be reflected by a change, in the opposite direction, in the value of Forex pair D.

Correlations between Forex pairs and crosses are variable. To the extent that they can differ significantly depending on the time frames they are measured over, say 10 minute, 30 minute or hourly periods. Or from one observation point to the next, for example new daily, weekly or monthly calculations. What’s more not only can the strength of this correlation vary or changeover time, so can its direction.

A Dynamic Marketplace

These dynamic relationships between the various Forex pairs and crosses make Forex one of the most exciting markets to be involved with. Presenting traders, as it it does, with countless opportunities on each business day. The skill of the trader is to be able to recognise those opportunities and to interpret what they mean for the prices of Forex pairs and crosses. Simply because, if we understand this information correctly we have the potential to profit from its application or translation into trades.

So to return to the example of the GBP USD Forex pair, or exchange rate, used earlier in this piece. If major news breaks which is positive for the US Dollar and negative for the Pound Sterling, it follows that this may also be positive for the valuation of other currencies versus the Pound Sterling. Or put another way, negative for the value of Sterling Forex crosses. As well as being potentially positive for the US Dollar versus its peers, or Dollar pairs. That amounts to a lot of instruments and a lot of potential price changes to consider and track.

Which Forex Pairs to Trade

It would be virtually impossible for a single trader to watch and monitor all of these prices, their changes and interactions, simultaneously. Not least because studies show that the human mind, on average, can only focus on or retain information about 6 or 7 things at anyone time. As a consequence of which traders tend to focus on a short list of instruments in which to trade.

That list could be a permanent fixture,that focuses on a handful of currency pairs that a trader follows closely and is very familiar with. For example USD JPY GBPJPY and AUD JPY. Or those Forex pairs which regularly exhibit the highest trading volumes such as EUR USD, GBP USD and USD JPY .

But equally a trader may prefer to trade what’s moving or likely to move on a given day or session. For example if based in Europe and trading the European session, the trader may choose to trade those Forex pairs that have been moving within the preceding Asian session. Hoping to benefit from that momentum, or perhaps to oppose it, in expectation of it fading and the price of the relevant Forex pairs correcting or re-tracing earlier moves.

Alternatively the trader may like to be guided by the Economic calendar of events.
As there is a regular well documented flow of key economic releases, from both developed and emerging economies. Of course a trader may prefer to look for specific, predetermined signals or indicators, that appear in the charts of Forex pairs and crosses. Of course this creates another potential “logjam” of information and traders will often use a screening tool or system to sort the “wheat from the chaff” leaving them with a manageable number of charts to look at and interpret.

Take a Look for Yourself

One of the best ways to get to grips with the concepts we have discussed in this article and get first hand experience of how they act on the prices of Forex pairs and crosses is to open a demo trading account.

A completely risk free and free of charge service, that provides users with access to an authentic simulation of the live trading environment. This is an ideal tool with which to try out trading in Forex pairs and crosses. To watch the news and data flow and resulting changes in price and sentiment that creates and to familiarise yourself with chart studies and indicators that can help you to understand how Forex pairs work and which to trade.