What exactly do you buy or sell when you make a foreign currency transaction? In reality, you are doing both actions, buying and selling.
A transaction of buying the EUR/USD at 0.8800 is actually buying the Euro and selling the Dollar at 0.8800 cent. If the Euro increases in value in relation to the dollar, the price would increase and the trader will make money. If for whatever reason, a trader could not execute an order using his trading or dealing platform, a verbal order to a broker could be the following:
"I buy 100,000 Euros and sell the dollar at the Market", one lot traded
or
"I buy 500,000 EUR/USD on a .8800 stop", five lots traded
or
"I buy 100,000 Euros vs. the Dollar at the market", one lot traded
What are required on all verbal orders are the amount, the Currency Pair, the rate and the type of order. Simply saying "I buy the Euro at the Market" is not good enough, as it does not say what counter currency the trader wants to sell.
Understanding the Concept
Since exchange rates represent what a fixed amount of currency is equal to in terms of another currency, we have seen there is just one price for the currency pair.
The movement of that price determines whether a currency is getting stronger or weaker.
If the EUR/USD exchange rate goes from 1.2097 to 1.2124, we have concluded that the EUR got stronger, the USD weaker.
Why?
When looking at foreign exchange rates or prices an action to buy the currency pair implies buying the base currency, or EUR, and selling the counter currency, or USD.
If the EUR/USD exchange rate moves higher, as expected, the trader can now sell the EUR/USD at a higher price. The difference represents a profit to the trader that was Long, or who bought the EUR/USD Currency Pair.
Another way of looking at it is, if at the rate 1.2097, a trader could exchange 1 EUR for $1.2097. At 1.2124, however, the same single EUR can now be exchanged for a higher amount of USD, in this case $1.2124 USD.
The EUR has strengthened or gotten stronger versus the dollar.
In the following examples, what has happened to the respective currencies in the Currency Pairs?
EUR/USD goes from 1.2096 to 1.2134
USD/CHF goes from 1.2450 to 1.2430
USD/JPY goes from 108.90 to 113.00
Answer: When the EUR/USD exchange rate goes from 1.2096 to 1.2134, the EUR gets stronger and the USD gets weaker. Remember, when one currency gets stronger, the other gets weaker.
Answer: When the USD/CHF exchange rate goes from 1.2450 to 1.2430, the USD gets weaker and the Swiss Franc gets stronger.
Answer:
When the USD/JPY exchange rate goes from 108.90 to 113.00, the USD gets stronger and the Japanese Yen gets weaker.
Lessons Learnt:
- The exchange rate of a currency pair reflects how much of the counter currency is been paid for the base currency at any point in time.
- If you buy one currency, you are selling another currency to obtain the currency you are buying.
- If you are LONG EUR/USD you have bought “long” Euro or the base currency and sold “short” the US Dollar or the counter currency.
- If you are SHORT EUR/USD you have sold “short” Euro or the base currency and bought “long” the US Dollar or the counter currency.
- When a currency pair or exchange rate goes from a low price to a higher price, the Base Currency is said to have strengthened or gotten stronger.
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