Forex Walkthrough

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Level 6 Trading - EUR-USD Pair

Due to the fact that the euro and U.S. dollar are the world's two largest currencies, representing the world's two largest economic and trading blocs, many multinational corporations conduct business in both the United States and Europe. These corporations have an almost constant need to hedge their exchange rate risk. Some firms, such as international financial institutions, have offices in both the United States and Europe. Firms that fit this description are also constantly involved in trading the euro and the U.S. dollar.

Because the euro/U.S. dollar is such a popular currency pair, arbitrage opportunities are next to impossible to find. However, forex traders still love the pair. As the world's most liquid currency pair, the euro/U.S. dollar offers very low bid-ask spreads and constant liquidity for traders wanting to buy or sell. These two features are very important to speculators and have helped contribute to the pair's popularity. In addition, the large number of market participants and the non-stop availability of economic and financial data allow traders to constantly formulate and re-examine their positions and opinions on the pair. This constant activity provides for relatively high levels of volatility, which can lead to opportunities for profit.

The combination of liquidity and volatility makes the euro/U.S. dollar pair an excellent place to begin trading for forex newcomers. However, keep in mind that it is always necessary to understand the role of risk management when trading currencies or any other kind of instruments. (For more information, see Forex: Money Management Matters.)

EUR/USD Facts
The United States and the European Union are the two largest economic powers in the world. The U.S. dollar is both the world's most heavily traded and most widely held currency. The currency of the European Union, the euro, is the world's second most popular currency. And since it contains the two most popular currencies in the world, the EUR/USD pair is forex's most actively traded currency pair.

The Unique Role of the U.S. Dollar
The U.S. dollar plays a unique and important role in the world of international finance. As the world's generally accepted reserve currency, the U.S. dollar is used to settle most international transactions. When global central banks hold foreign currency reserves, a large fraction of those reserves are often held in U.S. dollars. Also, many smaller countries choose either to peg their currency's value to that of the U.S. dollar or just completely forgo having their own currency, choosing to use the U.S. dollar instead. Additionally, the price of gold (and many other commodities) are generally set in U.S. dollars. Not only this, but the Organization of Petroleum Exporting Countries (OPEC) transacts in, you guessed it, U.S. dollars. This means that when a country buys or sells oil, it buys or sells the U.S. dollar at the same time. All of these factors contribute to the dollar's status as the world's most important currency.

Since the dollar is the most heavily traded currency in the world, most foreign currencies trade against the U.S. dollar more often than in a pair with any other currency. For this reason, it is important for traders starting out in the currency markets to have a firm grasp of the fundamentals that drive United States economy to gain a solid understanding of the direction in which the U.S. dollar is going. (To learn how to profit from a falling dollar, see Taking Advantage Of A Weak U.S. Dollar.)

The European Union Economy
Overall, the European Union represents the world's largest economic region with a GDP of more than $13 trillion. Much like the United States, the economy of Europe is heavily focused on services, manufacturing, however, represents a greater percentage of GDP in Europe than it does in the United States. When economic activity in the European Union is strong, the euro generally strengthens; when economic activity slows, as expected, the euro should weaken.

Why the Euro Is Unique
While the U.S. dollar is the currency of a single country, the euro is the single currency of 16 European countries within the European Union, collectively known as the "Eurozone" or the European and Economic Monetary Union (EMU). Disagreements arise from time to time among European governments about the future course of the European Union or monetary policy and when these political or economic disagreements arise, the euro can be expected to weaken. (To learn more about why the euro is so important, see Top 8 Most Tradable Currencies.)

Factors Influencing the Direction of the EUR/USD
The primary issue that influences the direction of the euro/U.S. dollar pair is the relative strength of the two economies. Holding all else equal, a faster-growing U.S. economy strengthens the dollar against the euro, and a faster-growing European Union economy strengthens the euro against the dollar. As previously discussed, one key sign of the relative strength of the two economies is the level of interest rates. When U.S.interest rates are higher than those of key European economies, the dollar generally strengthens. When Eurozone interest rates are higher, the dollar usually weakens. However, as we've already learned, interest rates alone can not predict movements in currencies.

Another major factor that has a strong influence on the euro/U.S. dollar relationship is any political instability among the members of the European Union. The euro, introduced in 1999, is also relatively new compared to the world's other major currencies. Many economists view the Eurozone as a test subject in economic and monetary policy. As the countries within the Eurozone learn to work with one another, differences sometimes arise. If these differences appear serious or potentially threatening to the future stability of the Eurozone, the dollar will almost certainly strengthen against the euro.

The list below shows the current members of the Eurozone as of January 1, 2009. When trading the euro/U.S. dollar pair, investors should carefully watch for troublesome economic and political news originating in these countries. If several Eurozone countries have weakening economies, or if newspaper headlines are discussing political difficulties among the countries in the region, the euro is likely to weaken against the dollar.

Members of the Eurozone


    • Austria
    • Belgium
    • Cyprus
    • Finland
    • France
    • Germany
    • Greece
    • Ireland
    • Italy
    • Luxembourg
    • Malta
    • Netherlands
    • Portugal
    • Slovakia
    • Slovenia
    • Spain

Trading the EUR/USD
Due to the fact that the euro and U.S. dollar are the world's two largest currencies, representing the world's two largest economic and trading blocs, many multinational corporations conduct business in both the United States and Europe. These corporations have an almost constant need to hedge their exchange rate risk. Some firms, such as international financial institutions, have offices in both the United States and Europe. Firms that fit this description are also constantly involved in trading the euro and the U.S. dollar.

Because the euro/U.S. dollar is such a popular currency pair, arbitrage opportunities are next to impossible to find. However, forex traders still love the pair. As the world's most liquid currency pair, the euro/U.S. dollar offers very low bid-ask spreads and constant liquidity for traders wanting to buy or sell. These two features are very important to speculators and have helped contribute to the pair's popularity. In addition, the large number of market participants and the non-stop availability of economic and financial data allow traders to constantly formulate and re-examine their positions and opinions on the pair. This constant activity provides for relatively high levels of volatility, which can lead to opportunities for profit.

The combination of liquidity and volatility makes the euro/U.S. dollar pair an excellent place to begin trading for forex newcomers. However, keep in mind that it is always necessary to understand the role of risk management when trading currencies or any other kind of instruments. (For more information, see Forex: Money Management Matters.)

Never Let a Winner Turn Into a Loser


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