The Mechanics of Currency Trading

The currency market has its own set of market trading conventions and related lingo, just like any other financial market. If you’re new to currency trading, the mechanics and terminology may take some getting used to. But at the end of the day, you’ll see that most currency trade conventions are pretty straightforward.

Buying and Selling Simultaneously

The biggest mental hurdle facing newcomers to currencies, especially traders’ familiar with other markets, is getting their head around the idea that each currency trade consists of a simultaneous purchase and sale. In the stock market, for instance, if you buy 100 shares of Google, it’s pretty clear that you now own 100 shares and hope to see the price go up. When you want to exit that position, you simply sell what you bought earlier. Easy right?

But in currencies, the purchase of one currency involves the simultaneous sale of another currency. This is the exchange in foreign exchange. To put it another way, if you‘re looking for the dollar to go higher, the question is “Higher against what?” The answer has to be another currency. In relative terms, if the dollar goes up against another currency, it also means that the other currency has gone down against the dollar. To think of it in stock-market terms, when you buy a stock, you’re selling cash, and when you sell a stock, you’re buying cash.

Currencies come in pairs

To make matters easier, Forex markets refer to trading currencies by pairs, with names that combine the two different currencies being traded against each other, or exchanged for one another. Additionally, forex markets have at given most currency pairs nicknames or abbreviations, which reference the pair and not necessarily the individual currencies involved.

The U.S. dollar is the central currency against which other currencies are traded. In triennial survey of the global foreign exchange market in 2004, the Bank for International Settlements (BIS) found that the U.S. dollar was on one side of 88 percent of all reported Forex market transactions.

The U.S. dollars central role in the Forex markets stems from a few basic factors:

• The U.S. economy is the largest national economy in the world.
• The U.S. dollar is the primary international reserve currency.
• The U.S. dollar is the medium of exchange for many cross-border transactions. For example, oil is priced in U.S. dollars. So even if you’re a Japanese oil importer buying crude from Saudi Arabia, you’re going to pay in U.S. dollars.
• The United States has the largest and most liquid financial markets in the world.
• The United States is a global military superpower, with a stable political system.