The Sovereign Society’s managing director, Erika Nolan, has given some useful baics about what you need to know before you jump into foreign-exchange investing.

If you’ve ever seen a quote screen for the foreign-exchange market, you may notice that currencies trade in pairs. For example, rather than just buying the Japanese yen, you’d buy the USD/JPY pair (the U.S. dollar vs. the Japanese yen). To invest in the FX market, you have to understand how these pairs work.

Currencies come in twos because a currency is only worth something when you compare it to another currency. (For example, you can only know what the dollar is worth if you compare it to the euro, yen, Aussie dollar, Swiss francs, Canadian dollar etc.)

In other words, the price of any currency is only relative to the price of another. But which is which?

The first currency in the pair is called the “base currency.” It’s always equal to “1″ of that particular currency. (So one dollar, one euro etc.)

The second currency in the pair is called the “quote currency.” It’s how much of itself “1″ of the base currency will buy you. This is the price you see on a quote screen because otherwise everything would be quoted as “1″ (which makes no sense).

Say I’m looking at the U.S. dollar against the Swiss franc. I’d find a market that quoted me the USD/CHF (”CHF” = the “Swiss franc”). The quoted price would tell me how many francs I could get for my dollar.

So let’s say the quoted price was .7500. Now this is where things get a little weird. That means for US$1 I could buy three quarters of a Swiss franc.

Let’s say I check the prices again the next day and the USD/CHF pair now trades at 1.25 (that would be a big day in the markets). Suddenly, my US$1 will buy one and a quarter Swiss francs. That means I’m buying MORE of the other currency.

When your dollar buys you more of anything, whether that’s foreign currency, gold, hamburgers, beer, whatever - your dollar is getting stronger.

The flipside is true too. If I check back the next day and I see a price of USD/CHF is .95. Then my dollar is buying less….and therefore you technically have less cash to spend.

That’s why understanding foreign currencies is so important: If you know how your dollars are performing against the other currencies in the world, you can diversify into stronger performing currencies.

Source: The First Thing You Need to Know Before You Jump into the FX Market