If you are going to trade in foreign currencies it is important to understand the pricing mechanism of the system. The relative rates of the currency or the rates between a pair of two currencies change not only on a day to day basis but on an hourly basis if not less. This is because the price of any currency is dependant on a host of economic and political conditions. Some of the important ones are interest rates, international trade, inflation and political stability. Foreign currency management specialists analyze these statistics in two ways i.e. technical analysis and fundamental analysis. Based on this system the price for each currency is determined and quotes are put up in terms of a pair of currency as well as a buying and selling price so that each quote has four components. Foreign currency trading quotes always show up in pairs of two currencies. This means a currency quote is made of two pairs of currencies. An example of this is the quote EUR/USD. The first currency is called the Base Currency, and the second currency is called the Pricing Currency.
When trading foreign currencies, you are always buying and selling the base currency. Let's say you buy one unit of USD/EUR. This means you are buying 100 dollar and selling at the same time 70.58 EURO at the current value.
The US dollar is usually the base currency, meaning the standard currency which is used when evaluating other currencies. For most major currency the first to appear, the base currency, is the USD. Examples of the currency trading quotes of the "major" currencies will then be USD/CAD (Canadian Dollar), USD/JPY (Japanese Yen) or USD/CHF (Swiss Francs).
But not in all cases the is US dollar the base currency. The Euro, British pound and Australian dollar are exceptions. So the EUR, GBP and the AUD are shown before other currencies or even the dollar and are considered base currencies in that case. In this case you will see a currency trading quote such as GBP/USD or AUD/USD, meaning the base currency for them is not the USD.
As an example of how actual trading will be done let us assume that the price quote between Euro and US Dollar is EUR/USD 1.3910/15. This means that for one Euro you can buy 1.3910 US Dollars or pay 1.3915 US Dollars to buy one Euro. You have a hunch that the Euro should be worth more as compared to US Dollar and may appreciate. So you invest in the forex market and buy say 100,000 Euros with 139,150 US Dollars. Now you wait until the value of the Euro appreciates against the US Dollar.
You need not actually spend this much money. You only need 1391.50 US Dollars as margin money in your account. However this will depend on your forex account provider. Most online forex brokers usually offer a margin account with a 1% guarantee.
Now, if the Euro does appreciates as you had anticipated you would find the quote on the forex market. Supposing it now reads as EUR/USD 1.3960/65 which means that the 100,000 Euros which you have can now be sold on the current price of 1.3960. This will give you 139,600 US Dollars thus making a profit of US $450. In forex trade market this difference in rate is referred to in “pips”. The difference between the earlier rate of 1.3915 with the new rate of 1.3960 translates into a difference of 45 pips.
If you are finding the above figures going over your head there is a simpler way of knowing when you are making a profit and how much. Most online forex sites offer their investors an easy-to-use program to calculate profits or loss for every transaction that is open to you at any particular time. However, it is still important to understand how this is being done as explained above.