If I say that EUR/USD at the moment on the market is trading at 1.3500, it means that 1 euro (base currency) corresponds to 1.3500 dollars (quote currency), or, in other words, that if you want to buy 1 euro, you need 1.3500 dollars.
It goes without saying that when the Euro currency appreciates in the EUR/USD exchange, it does so at the expense of the Dollar currency, so if Euro appreciate Dollar depreciates, and vice versa.
EUR/USD at 1.5000 indicates that it will take 1.5000 U.S. Dollars for 1 Euro, that means more dollars compared to the previous example. In fact, the EUR/USD exchange rate in this example has risen in favor of the Euro currency, leading to a depreciation of the Dollar currency.
A EUR/USD 1.1000 means that to buy 1 Euro you need 1.1000 U.S. Dollars, so less dollars than the two previous examples.
In fact, in this example, EUR/USD dropped at the expense of Euro, encouraging the appreciation of the Dollar.
Currency exchange: a life example for a better understanding
Our friend Marco from Italy recently completed his studies and decided to have a good working holiday in the US, to have a great experience and learn a new language while working. Since his parents can afford it, they gave Marco a bonus of € 10,000 for the trip that, added to the other € 10,000 that Mark has put aside over the years, made a total of € 20,000.
So, Marco left his home, and once arrived in America he changed its 20,000 Euros in U.S. Dollars. At the moment he changes his money, EUR/USD was quoting 1.5000, and consequently he took $ 30,000 U.S.
Marco spent 6 months in America, traveling, having fun, knowing a lot of people and learning English. But, contrary to the initial good intentions, Marco didn’t work a single day, spending in six months of vacation the sum of 6,000 usd.
On his return to Italy, he had 24,000 U.S. dollars, which he promptly changed in Euros at the EUR/USD exchange rate of 1.1000 (as you can see, within 6 months of vacation, the euro has depreciated a lot, causing an appreciation of the dollar).
Marco was very surprised and pleased with what he sees, because the clerk handed him 21,816 euro. That is € 1.816 more than the sum he had when he left Italy.
How is that possible? Marco left with 20,000 euro and came back with 21,816 euro, after living in America for 6 months without working, therefore using his own financial resources.
Marco unknowingly has exploited the Forex market, he has done in 6 months what investors, speculators and traders, very often do daily.
The currency market mathematically
Let’s analyze mathematically the situation, in order to understand in practice what it means to be a Forex trader and an investor or the foreign exchange market.
We have said that Marco started with 20,000 euro, changing them once arrived in the United States. Therefore, the operation he has done was to use the 20,000 euro to buy Dollars.
We said that, at the time of the transaction, the EUR / USD rate exchange stood at 1.5000, which is like saying that to buy 1 euro you need 1.5000 U.S. dollars, or that with 1 euro you can get 1.5000 U.S. dollars.
1 euro x 1,5000 = 1,5000 dollars
20.0000 euro x 1,5000 = 30.000 dollars
On the way back, after spending 6,000 dollars, our friend Marco had 24,000 dollars left, which he changed in euro at the exchange rate of EUR/USD 1.1000.
Therefore, an exchange rate with a much weaker Euro against the Dollar, if compared with the rate at the time of Marco’s departure.
1 euro x 1,1000 = 1,1000 dollars
1 dollar x (1/1,1000) = 0,9090 euro
Therefore 24,000 Dollars x 0,9090 = 21,818 Euro
(or, to simplify the calculation, you can make 24,000 dollars DIVIDED by the exchange, so 24,000 / 1.1000 = 21,818 euro)
There you have it.
Trading on the currency market means buying a currency pair, or a currency exchange, when it has a low value to sell it when it has a higher value, or selling it (I’ll explain what that means) when it has a high value and then buy it back on the market when it has a lower value.
In the world of trading we use two specific terms to describe the two scenarios, and these are LONG and SHORT.
- “To go long” means buying the base currency (on the left) and selling the quote currency (on the right), hoping that the base currency will rise in value, and then sell it to collect the difference. In other words, the exchange rate is rising.
- “To go short” instead means to sell the base currency and buying the quote currency, hoping that the base currency will lose value, so to buy it at a lower price and collect the difference. In other words, the exchange rate is going down.