The base currency is the first half of a currency pair, the currency you are selling. The second half of the pair is known as the quote currency, the one which you are buying. For example, if you see a currency quote that reads USD/JPY 123.90, it means that you are using 1 USD to purchase 123.90 JPY.
The base currency is always equal to 1, although the quote currency can be worth more or less than the base. If the quote currency is worth less, it will be above 1 and if it is worth more, it will be worth less than 1. Often, the base currency is USD, although EUR, GBP, and AUD are also common base currencies.
The most popular currency exchange is the Foreign Exchange Market, or Forex. Established in 1971, Forex is the largest trading market in the world, with over $4 trillion worth of currency traded every single day.
BENEFITS OF TRADING CURRENCIES
Speculating on currencies in the Forex market offers many advantages for astute investors:
- Forex has incredible liquidity (over $4 trillion in daily trades), allowing trades to be executed immediately.
- Forex operates 24 hours a day, Monday to Friday.
- There aren’t any commission fees on currency trading, and the spread in Forex tends to be lower than the spread in other securities. This makes currency trading extremely cost-effective.
- Short sales are quick and simple to execute.
- High volatility allows sharp investors to profit quickly when their trades are successful.
THE BASICS OF TRADING CURRENCIES
When you’re looking to trade a currency, you’ll find a currency pair, such as USD/JPY = 121.25. In this example, the US dollar is the base currency, and the Japanese yen is the currency you are purchasing. One USD would buy 121.25 JPY.
In Forex, the USD is most often the base currency. However, other currencies such as the British pound, the EU’s euro, and the Australian dollar are also used as base currencies.
To successfully trade on Forex, you’ll need to know several more terms:
Bid price: This is the current price at which the broker will buy the base currency.
Ask price: This is the current price at which the broker will sell the base currency. This is always marginally larger than the bid price.
Pip: This is the smallest price movement a currency can make. Most currencies have a pip between two and four decimal places. Even these miniscule movements, however, can be the difference in thousands of dollars of value.
Spread: This is the difference between the bid price and the ask price. The spread is usually only several pips, and is the broker’s way of making a profit on trades.
WAYS TO TRADE USING BASE CURRENCY
There are two main reasons that investors decide to invest in the currency market. The first is speculation. This can be long-term or short-term, occuring when you see the potential for currency to significantly change value. Investors will invest in a currency if they believe it is going to become stronger, and will short it if they believe it’s going to weaken.
The second main reason investors will risk funds on the currency market is to hedge against risk. If you live in the United States and your entire portfolio consists of U.S. stocks, securities, and currency, you’re at risk if the US economy falters. Therefore, investing in foreign currencies would hedge your bets and spread the risk out a bit.
RISK OF CURRENCY TRADING
The reason that currency trading is so risky is that base currencies can be traded on leverage. This means that you can control much more currency than you actually purchase. Because your investment is miniscule in comparison to the capital you control, your losses are rapid and devastating. If you trade on 100:1 leverage, for example, a 1% drop in value will wipe your investment out. Leverage isn’t always a bad thing, however, as it means that your gains are also exponentially larger. You simply need to evaluate your trade and decide if the risk is worth it.