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I am starting to study FOREX again and one thing about trading on the market through means available to me personally is that one can take positions on 'currency pairs'. This has made little sense to me because I'm looking for some sort of physical relation to what 'taking a position on a pair' really means.

One thing that shed some light was the 'Exposure' tab in MetaTrader. My base account is in USD as that is the currency that I have deposited into the account. If I take a position on USDCAD, what I think is that I take some of my USD in my account and purchase an amount of CAD with it at the current USDCAD exchange rate. My exposure tab is then updated with an exposure on the CAD currency of the amount that I have purchased.

I then thought, what about purchasing from something not starting with USD, such as AUDJPY. This causes exposure of X in AUD and an exposure of -X in JPY, so such a position will cause a long purchase of AUD and a short sell of JPY. So now my positive exposure is in CAD and AUD and negative in JPY.

So trying to simplify, I feel that I have bought CAD and AUD with my USD and short sold some JPY for USD. Am I correct in this thinking? If not, could someone explain what is really going on when I take a position against a currency pair?

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Are you talking about having two open pairs? I think this is what is becoming confusing. I know you are Canada. But it's still your choice to trade whatever currency pair you wish. –  JoeTaxpayer Jun 23 '12 at 18:50
    
I didn't realize your from canada. So just to clarify, you said "My base account is in USD" so I am assuming this is a hypothetical and the USD would be your native currency(the money you would use to buy a tomato for example). Is this correct? –  Kirill Fuchs Jun 23 '12 at 18:56
    
I considerably reworked the answer, hopefully its a little easier to follow now. I'm still using USD as the native currency. –  Kirill Fuchs Jun 23 '12 at 20:31
    
I am Canadian but I'm using USD as the base currency because the MT practice accounts I can open are all in USD. –  Burton Samograd Jun 24 '12 at 1:55

2 Answers 2

up vote 12 down vote accepted

So let's start from the beginning:

Here's what we know:

  • Currency can only be valued when compared to another currency. So each time you enter a position on a currency it is always relative to another currency. So the currency pair can actually be thought of as one unit.
  • The first currency of a currency pair is called the "base currency", and the second currency is called the "quote currency".
  • If you buy a currency pair, you buy the base currency and sell the quote currency.

See - Currency Pair - Investopedia


So now let's begin breaking your question down:


If I take a position on USDCAD, what I think is that I take some of my USD in my account and purchase an amount of CAD

(I assume you mean "long position")

No, if you execute a buy(long position) on USD/CAD this means you are buying the USD vs the CAD(your betting the USD will go higher vs the CAD). Remember the USD is the base currency and the CAD is the quote currency. So in this case you would actually be borrowing CAD and purchasing more USD.

What your looking for would be to execute a sell(short position) on USD/CAD - this means you are using USD to buy CAD(betting CAD will go higher vs the USD).

Now if I switch the base currency and the quote currency (e.g: CAD/USD). Then going long CAD/USD would be the same thing as going short USD/CAD, that's because in every currency trade you are always going both long one currency and short another. This leads us back to the first rule from the beginning.

Hopefully that made sense.


Onward to AUD/JPY, CHARGEEE!


You are correct in saying:

so such a position will cause a long purchase of AUD and a short sell of JPY

But your analysis on USD/CAD is still incorrect for the same reasons as before.


Ok gents we're almost home!


So trying to simplify, I feel that I have bought CAD and AUD with my USD and short sold some JPY for USD. Am I correct in this thinking?

No you did not buy AUD with USD, at least not directly(key word). When going long AUD/JPY, you are borrowing JPY then using JPY to buy AUD. So now to exit this trade you would go short AUD/JPY which means your using the AUD to buy back the JPY after which you would give back the JPY you borrowed. Any extra JPY would be your profit (or loss if the trade went the other way).

But there's more: We also have to understand that our native currency is USD, meaning when we go to a store, no one cares about JPY they only want to see USD. So at the end of the day everything must calculate to its USD equivalent. Your brokerage firm also will not accept your maintenance-requirement or your fees in any other currency but your native one.

So for example: If you made 100 JPY profit from your trade, how much profit did you make? hint: It's not 100 JPY.

Yes you may have added 100JPY but that means absolutely nothing to us, because all we care about is USD! So the right answer is we made "whatever 100JPY = in USD at the time we convert it".

Your brokerage firm will take care of all the day to day calculations for you in real time so you don't have to sit there contemplating how much your profit really is or what your maintenance-requirement is. To put it simply every trade you make must always come back to your native currency and hence why you are indirectly buying AUD with USD because the real value of the amount you make is dependent on the JPY vs the USD, simply because the USD is what you pay your bills with. So EVERYTHING has to come back to USD.

See the section called - Converting Profits and Losses in Pips to Native Currency


WOOHOO We made it!


So let's keep reading:

Taking a look at the answer to - WSJ article about CFDs - am I missing something? will help as it explains a-lot of what you asked.

Baby Pips - is a good site for Forex explanations.

Specifically this article gives a good explanation about what your asking.

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So a taking a position on currency pair is (according to investopedia) 'the simultaneous buying of one currency (the base) and selling of another (the quote)' combined into one action. Like I said in the question, I had a feeling that this was happening, but I'm trying to understand it fundamentally. –  Burton Samograd Jun 23 '12 at 17:00
    
@JoeTaxpayer Yep thanks, I corrected it. –  Kirill Fuchs Jun 23 '12 at 17:49
    
@BurtonSamograd I've rephrased the answer and clarified a few more things. Let me know if there is something still confusing you. –  Kirill Fuchs Jun 23 '12 at 20:29
    
It's getting clearer...but...when I borrow the JPY to buy the AUD, what I'm seeing is that the borrow is executing at the current USDJPY rate causing my margin to be reduced which to me looks like I am 'buying' JPY with USD to buy the AUD. I'm trying to relate this system to the margin amount in my account, and how all this relates to the actual purchase and transfer of wealth from one entity to another. This is a good answer but it's still leaving me with some questions especially when relating to my margin after a trade. –  Burton Samograd Jun 24 '12 at 1:53
    
Also, when you have an account you are automatically long on the base currency since that is what you are holding and using to 'get into the game' by taking positions and how you 'keep score' because that's the point of the game (to end up with more of your base currency so you can buy more tomatoes :) I'm not actually trading yet, just trying to make some heads and tails of the methods that are available with a trading terminal. –  Burton Samograd Jun 24 '12 at 1:58

There is more to it than being long one currency and short another.

As I posted here How does purchasing your own country's currency as part of a currency pair work?

When you "buy" the USD/JPY, you're not converting your dollars to dollars. Even when you "buy" EUR/JPY, you're not converting dollars to euros.... what you're doing is borrowing yen and lending euros.

From http://www.dailyfx.com/forex/education/learn_forex/using_dailyfx/fundamentals/2010-01-19-2142-Understanding_Foreign_Exchange_Rollover.html

Rollover is the interest paid or earned for holding a currency spot position overnight. Each currency has an overnight interbank interest rate associated with it, and because forex is traded in pairs, every trade involves not only 2 different currencies but also two different interest rates. However, unlike what many traders think, foreign exchange rolls are not based on central bank rates. Instead, forex rolls are constructed using forward points which are mostly based on overnight interest rates at which banks borrow unsecured funds from other banks. After all, the foreign exchange market works over-the-counter. Market and spot trades need to be settled and rolled forward every day. If the interest rate on the currency you bought is higher than the interest rate of the currency you sold, you will earn a positive roll. If the interest rate on the currency you bought is lower than the interest rate on the currency you sold, then you will pay rollover.

Since interest is charged and paid, you don't buy or sell anything... you borrow and lend and the currency you funded your account with is the collateral.

If you're simply converting one currency to another, then why are you paid interest to hold a currency? Does the fed mail you an interest check for holding US dollars in your wallet? The only way you get paid interest is by lending the currency out.

So it may be more correct to say when you "buy" the USD/JPY, you've borrowed yen and lent dollars. More precisely, you've borrowed yen from an interbank, sold them for dollars, then lent the dollars to an interbank for an interest payment. The dollars in your account never move. Its just the collateral. To "buy" $1000 of USD/JPY, you need only have $20 in your account. $30 for the EUR/JPY. Why bother to convert $30 on such margin?

If you really wanted to convert your dollars to euros, you'd have to go to europe or find a bank that can make the exchange, or a private party willing to swap. Since you've taken possession of euros and haven't lent them out, you won't get paid an interest rate for holding the euros. You also won't get charged an interest rate for borrowing dollars, since you didn't borrow them, you owned them outright in the beginning.

Of course, if you wanted to find a US bank to loan you dollars, then fly to europe and convert your dollars to euros, then find someone looking to borrow euros,,, you could accomplish the same thing a forex account does by simply buying EUR/USD. In the meantime, you have nothing in your hand but an obligation to pay interest to the US bank and the expectation of an interest payment from the person who borrowed the euros from you. To close the trade, you'd have to demand full payment from the one who borrowed your euros, convert back to dollars, then pay the loan at the US bank.

In Summary

If you buy AUD/JPY, you've borrowed yen and will be charged an interest rate. You've lent out AUD and will receive an interest rate. You don't hold either one of them. The margin missing from your account is the collateral. Even though you don't hold either currency, you get paid (or charged) the difference in the exchange rate when the trade reverses. The amount you get paid per pip is figured in the "pip cost" or "pip value" which is listed on the quote screen of the forex trading app. If your account is funded with USD and you buy 10k of EUR/USD, you get paid $1 per pip. If you buy EUR/GBP, you get paid $1.60 per pip because your account is in USD, not GBP.

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