Friday, July 3, 2020

How to Choose a Currency Pair to Trade Forex

NBHM Research Team

Choosing the Right Currency Pair to Trade

 

A vital part of your trading plan is to choose the right asset to trade. Here are some things to consider while choosing a forex trading pair.

One of the largest financial markets, the forex market, operates practically 24 hours a day, from 5pm EST on Sundays to 4pm EST on Fridays. Traders engage in buying and selling of a large number of currency pairs across the world. The forex market also has the highest liquidity in the global financial space. Approximately 180 legal currencies exist globally, but a majority of the trading volume is represented by only a small fraction of them.

Choosing the right currency pair to trade can be overwhelming. It is a significant aspect in meeting one’s long term financial goals. This confusion is not only due to the sheer number of choices available. Every currency pair has its own trajectory and market movement. The personality of the pair needs to be suitable for a specific trading strategy, otherwise it might not bear the desired results.

There are many ways to go about it. Let’s take a look at some of the aspects.

 

Liquidity Could be a Primary Motive for Beginners

Major currency pairs are the most traded ones in the market. When traders are starting out, they would not want to be left with a pair that has little or no interest, and which makes them difficult to buy and sell. In other words, seven major currencies have the highest liquidity in the forex market. Currency pairs with larger liquidity tend to have lower volatility and are, thus, less risky, compared to others. Higher liquidity also results in lower spreads offered by forex brokers, which brings down trading costs.

The dominant and most widely traded currency is the US Dollar. It is the reserve currency of the world, due to the sheer size and power of the US economy. The Bank of International Settlements’ 2019 Triennial Survey of turnover in the OTC FX markets revealed that despite its declining status, the US Dollar was still part of 88% of all FX trades. The USD is followed by the Euro and the Japanese Yen in being the most traded currencies in the world. Together, these make up the 4 major currency pairs:

  1. EUR/USD: Market share of Euro trading expanded to 32% in 2019, second only to the US Dollar. Combined with the mighty Dollar, this pair might represent a stable option for traders, due to typically low volatility. The pair is associated with the lowest spreads.
  2. GBP/USD: Once considered one of the biggest pairs, this one has been extremely volatile since the Brexit referendum of 2016. Nevertheless, its volatility provides a lot of swing trading opportunities. If traders are looking for opportunities to make higher gains (via higher pip movements), this could be the currency pair to consider. However, the risk exposure will be higher as well.
  3. USD/JPY: This pair is highly sensitive to broad market sentiment. It is considered as a safe-haven currency pair. Intense market volatility and economic downturns are often followed by a rise in price for this pair.
  4. USD/CHF: The Swiss Franc is also considered a safe-haven currency, due to the politically neutral stance adopted by Switzerland. Just like the USD/JPY, this pair also tends to rise in value during geo-political unrest and economic uncertainty.

The major currency pairs have shown a tendency to move in the direction of their long-term trends in recent years. Trend or momentum trading is a key strategy adopted by new traders. While trading majors, traders need to consider whether the price of the pair is higher or lower than what it was 3 to 6 months ago, and then trade in the same direction of the overall trend.

 

Volatile Pairs – High Risk and High Gain Potential

Currency pairs with lower liquidity or trading volume tend to exhibit higher volatility. Volatility levels differ across forex pairs. There are minor currency pairs that tend to be more volatile than the rest, partly because they are less traded and also because some belong to volatile economic and political climates. Some examples include:

  • AUD/JPY
  • USD/TRY
  • GBP/AUD
  • CAD/JPY
  • AUD/CHF
  • AUD/CAD
  • NZD/JPY

Pairs that don’t contain the US Dollar are called crosses. Not all of them are minor currency pairs. In other words, while all minor pairs are crosses, not all crosses are minors. A few currencies, like the Australian Dollar (AUD), Canadian Dollar (CAD) and New Zealand Dollar (NZD) are called commodity currencies. These currencies are hugely tied to price fluctuations of commodities like oil, iron ore, wood and more, which their respective countries are top exporters of. This makes them highly volatile.

Volatility can also spike during times of economic data releases and breaking news announcements. This can happen in major currency pairs too. For instance, news concerning Brexit developments makes the GBP/USD pair highly volatile.

Mathematician Benoit Mandelbrot identified the phenomenon of volatility clustering in the forex market. He proposed that if a pair moves by more than its average volatility for some time, it will reverse over the short term. Traders tend to take advantage of this phenomenon through breakout trading, where they observe a sudden price breakout of a relatively quiet currency pair and get in on the move, until the level goes down after a while.

Traders need to consider that high volatility comes with the increased risk of negative slippage. This means that trades don’t get executed at the price decided by the trader. So, risk management tools are essential to trade volatile pairs.

 

Trading Hours Perspective

There are 4 major sessions in forex trading: New York, London, Tokyo and Sydney. The markets are considered more active when two sessions overlap. Some currency pairs, like the AUD/USD and USD/JPY, are most liquid in the Asian session, which lasts from 7am EST to 10pm EST. Similarly, the EUR/USD and GBP/USD are highly active at the intersection of London and New York sessions, which is 8am EST to 12pm EST.

 

Trading Correlated Pairs to Hedge Investments

Correlation is the statistical measure of relationship between two financial assets, in this case, two currency pairs. Over time, traders who would like to move on from major currency pairs to invest in more volatile pairs need to consider risk management.

The degree of correlation between two pairs gives an idea as to what extent their prices move in the same, opposite or any random direction, in a given timeframe. This shows the extent of risk a trader is exposing their forex trading account to. If they get into long positions in multiple pairs with strong positive correlations, the account will be subjected to more directional risks. Here are some examples of strong positive and negative correlations.

Currency pairs with strong positive correlations:

  • EUR/USD and GBP/USD
  • USD/JPY and USD/CHF
  • EUR/USD and AUD/USD
  • EUR/CHF and EUR/USD

Currency pairs with strong negative correlations:

  • EUR/USD and USD/CHF
  • AUD/USD and USD/CAD
  • EUR/USD and USD/JPY

Just like levels of volatility, currency correlations also change over time. This can be due to changes in monetary policies, fiscal policies and commodity market trends.

Before choosing any currency pair to trade, it is useful to analyse market news and global happenings, as well as implement appropriate risk management strategies.

 

References:

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