There is much to learn for the new forex trader before they invest their hard-earned money in this highly liquid but highly dynamic market. Apart from the usual trading regulations, platforms, order types and technical indicators, price trends and a whole plethora of terms need to be known. One of the most complex things to understand could be exchange rate quotations.
Foreign exchange is, after all, the act of converting one currency into another. So, exchange rates are the mutually agreed upon conversion rates. Currencies are always traded in pairs, which is why quotes will always tell us a price of one currency with respect to another. There are two terms a trader will often hear in the forex markets: direct quotations and indirect quotations.
But first, let us capture some basics of forex quotes.
If we take the example of the EUR/USD, the first currency (EUR (Euro)) is actually the base currency, while the second currency (USD (US Dollar)) is the quote currency. Quote currency is often also referred to as the counter currency.
EUR/USD = 1.1387
The above figure represents the EUR/USD quote for June 25, 2019. This means that to buy one unit of EUR, we would need to spend US$1.1387, or to put it simply, €1 is worth $1.1387. So, if a trader is buying a currency pair, they are buying the base currency and selling the quote currency. If, on the other hand, someone is selling a currency pair, the base currency is sold in exchange for buying the quote currency.
Now, we move on to direct and indirect quotations.
Depending on which currency, domestic or foreign, is taken as the base currency, and which is taken as the quote, quotations get categorised as direct and indirect. This also depends on the geographical location of the trader.
A direct forex quote is defined as fixed units of a foreign currency, denominated in terms of variable units of the base currency. This shows us how many units of the local currency are needed to buy a single unit of the foreign currency (in most cases, USD). For a US citizen, the USD/GBP quote of 0.7835 is the direct quote, while the conventional GBP/USD quote of 1.2763 will be indirect.
It is to be noted that the US Dollar, being the most traded currency in the world, is mostly considered as the base currency in a maximum number of pairs. Notable exceptions include GBP/USD and EUR/USD, both of which are considered highly liquid pairs for trading. The Great British Pound was the world’s dominant currency until the rise of the US economy, in the post-WWII era. The Euro, on the other hand, replaced major European currencies like the French Franc, Dutch Guilder and German Marc in 2002, which is why the ECB mandated that the Euro always be the base currency against all major currencies.
In this price quotation method, if the domestic currency appreciates (denoted by a lower exchange rate), it means that a smaller amount of that currency would need to be exchanged to get one unit of a foreign currency. Similarly, if the domestic currency depreciates, a higher amount of it will be required to buy one unit of the foreign currency. The direct quote is the most widely used connotation in the forex market. This is the de-facto method of quoting forex prices. Most quotes you see on trade terminals like MT4 and MT5 are depicted as USD or another major currency as the base.
The amount of local currency received when you sell one unit of a foreign currency is denoted as an indirect quotation. The foreign currency becomes the quote currency in this case, with the domestic currency acting as the base currency. If your domestic currency is the Euro, the EUR/USD quotation will be an indirect one. This tells you how many US Dollars are required to buy one euro.
An indirect quote is the opposite of a direct quote. So, the domestic currency becomes the base currency and the foreign currency is the quote currency.
When it comes to trading forex via quotes, the concept of lots is also important to understand. A quantity of 100,000 units of base currency is equal to one standard lot.
Suppose you are trading 0.02 lots of USD/JPY, it means that you are trading Japanese Yen worth $2,000.
Unlike direct quotations, indirect rates have a direct relationship with the domestic currency. When the domestic currency appreciates, the indirect quote also goes up.
Once you are familiar with the concept of direct and indirect quotes, cross-currency rates can be easier to understand. A cross rate is the currency rate between two currencies, none of which is the domestic currency of the country where the exchange quote has been provided.
Such rates are mainly used to calculate the exchange rates of non-USD pairs, such as the AUD/CAD or EUR/JPY. A majority of these cross pairs have slightly wider spreads than the usual dollar denominated currency pairs. They are used to create arbitrage moves by traders, which involve simultaneous buying and selling of two or more currencies, leveraging on their price differences. Traders, importers, exporters, companies and tourists are able to transact in foreign currencies, while allowing repatriation of profits or earnings back in their domestic currencies.
It is vital that traders understand the nuances of currency quotations, since their pips and spreads are attached to it, which translate into their profit margins. It is also critical to understanding market gaps and slippages. It is important to remember that forex quotations can be interpreted in various ways, depending on the location where they are being provided, types of quotations being offered and also the market norms and conventions.