When we buy something in a shop, a price tag shows us the price of an item in the domestic currency. For example, we pay $12 for a book which is common practice for us.
In the Forex market, we always trade one currency against another. Therefore, the traditional price tag is not enough in this case. For example, our trade is represented by the US dollar and the euro. In order to calculate the price of a currency, we need to know how much 1 US dollar is worth in euros or the price of 1 euro in US dollars. That is, we need to know the exchange rate of one currency to another. Such an exchange rate is indicated by an A/B quote. In this case, the quote looks like EUR/USD.
The first currency in the quote is called the base currency, while the second one is called the quote currency. For any currency pair in the Forex market, the position of the currency in the quote is strictly established. For the EUR/USD pair, this is always EUR/USD and never USD/EUR. Thus, the euro is the base currency and the US dollar is the quote currency.
How is the position of the currency in the quote determined? Let's distract ourselves from the Forex market for a while and take a closer look at a country like Japan. Historically, each country has its own rules for recording quotes. These rules are usually established to present information in a convenient way. Thus, it is easier to say that you need 104.78 yen to buy 1 US dollar and not vice versa. Therefore, USD/JPY represents the exchange rate for the Japanese yen. The exchange rate can be quoted in two ways: the direct quote, when one unit of foreign currency is expressed in terms of domestic currency, and the indirect quote, when one unit of domestic currency is expressed in terms of foreign currency. In our case, USD/JPY is the indirect quote for Japan.
In the Forex market, there is no such thing as a domestic currency. The main reserve currency is the US dollar. For quotes with the US dollar, the rules for recording currency quotes in the respective countries are used. In regards to the US dollar, the concept of direct and indirect quotations is applied. Thus, if the US dollar is the base currency in a currency pair, it is an indirect quote. When the US dollar is the quoted currency in a currency pair, it is a direct quote. Let’s analyze the USD/JPY pair, for example. In this case, the US dollar is the base currency in the indirect quote. Meanwhile, in the GBP/USD pair, the US dollar is the quote currency in the direct quote.
When we say that the A/B quote is X, we mean that we can buy or sell 1 unit of the base currency for X units of the quoted B currency. For example, if we say, that the EUR/USD quote is 1.2845, we mean that we can buy or sell 1 euro for 1.2845 US dollars. In other words, buy/sell trades always refer to the base currency. The quotes denominated in US dollars are listed below:
Thus, we can buy/sell 1 euro for 1.2845 US dollars and 1 US dollar for 97.5 Japanese yen, etc.
Importantly, providers do not always specify direct and indirect quotes on the quotes lists on the Internet, implying that users are well-informed and understand where the quote and the base currencies are. For example, you see that the JPY/USD pair is 97.50. This quote is indirect against the US dollar which means that USD/JPY is 97.50. Sometimes, quotes against the US dollar are indicated with only one currency. For example, JPY is 97.50. Therefore, it is important to study the currency quotes that you are going to trade, as well as to know what kind of quote - direct or indirect - it is against the US dollar. Otherwise, you may come to a wrong decision on the deal. For example, the Swiss franc is the quote currency against the US dollar. A quote of 1.1623 implies that you can buy/sell 1 USD for 1.1623 CHF and not vice versa.
Apart from that, the understanding of how quotes change is key. Your main goal in the Forex market is to buy cheaper and sell at a higher price. For direct and indirect quotes, changes in the exchange rate have the opposite meaning. For a direct quote against the US dollar, as in the GBP/USD pair, an increase in the quote means a rise in the British pound and a fall in the US dollar. Meanwhile, for the USD/JPY pair, it shows the strengthening of the US dollar and the weakening of the Japanese yen. Therefore, when you close a position in the Forex market, it is essential not to confuse the type of the quote against the currency you are interested in.
The accuracy indicator - the number of decimal places after the decimal point - is used for different quotes. A minimum change in a quote is called a point or a pip, its value varies for different quotes. For example, 1 pip for EUR/USD and USD/JPY is 0.0001 and 0.01, respectively. The larger figures change slowly.
The price of 1 pip denominated in US dollars is of particular interest. In the case of a direct quotation against the US dollar, it is not a problem to determine the value of 1 point, since it is already indicated in USD. In case of an indirect quote against the US dollar, the value of 1 pip in US dollars is calculated by means of a special formula. We will come back to this later when we learn how to calculate profit and loss.
In this chapter, all quotes have been expressed in spot (current) prices. We decided to keep concepts such as the bid/ask price, spread, and cross rates for later. These concepts will be described in the coming chapters.