Forex Focus
Access to foreign exchange trading has opened up exciting trading options for the retail trader. You can now trade alongside corporations and institutions in a highly liquid market that is global, traded around the clock, and highly leveraged. Before jumping into this market, however, we must understand the factors that affect the forex market. With that in mind, STOCKS& COMMODITIES has introduced Forex Focus to better prepare the retail trader to participate in the currency market.
Which Currency Pairs Should I Trade?
In the currency smorgasbord, which pairs offer the best trading opportunities? Try some of these to decide.
by Grace Cheng
The currency market can be likened to a buffet table, where you can select from a variety of currency pairs to trade. With more than 30 currency pairs available, the currency trader has overwhelming number of choices, but having so many options is not unlike a young adult suffering from "quarter-life" crisis, a recent social phenomenon whereby an individual feels so lost when faced with a multitude of career options that his life seems to be at a standstill.
When choosing which currency pairs to trade, besides the usual factors such as liquidity, amount of spreads, technical signals, and so on, other interesting ways of deciding are available. In this article, I will highlight some approaches I use to decide which currency pairs offer the best trading opportunities.
STRONGEST/WEAKEST PAIRING
Currencies are always traded in pairs, with one currency exchanging for another. When you "long" a currency pair -- that is, buying the first currency (known as base currency) and simultaneously selling the second currency in a pair (known as counter currency) -- you are betting on the price appreciation of the base currency and on the depreciation of the counter currency. You want one currency to become stronger and the other to be weaker in the same pair.
Many currency traders fail to recognize they must consider the economic and monetary conditions of both countries in a currency pair instead of just one. If you sell a currency of a country that shows signs of robust economic growth and simultaneously buy a currency of a country whose economy is in bad shape, you are setting yourself up for a very low probability of success. On the other hand, if you buy the currency of a country expected to raise interest rates and simultaneously sell the currency of another country expected to cut rates, you would have a higher chance of success than if you were to buy and sell currencies of countries both expected to raise rates.
Let me give you an example. Throughout 2005, the Federal Reserve Bank was in the process of raising interest rates at a "measured" pace till policy rates hit at least what was perceived to be the midpoint of the "neutral" policy range.
Meanwhile, in mid-2005 in Europe, inflation in the Eurozone was at 2.5%, the fourth month it had been at or above the upper 2% limit that the European Central Bank (ECB) is meant to adhere to under the Maastricht Treaty. So the ECB was preparing to begin implementing tighter monetary policy after having its rate unchanged at 2% for a long time, although the timing had not yet been fixed. Since rising interest rates are good for that country's currency as global investors shift their money into higher-yielding assets from lower-yielding ones, this tightening tendency by both the US and the European central banks created a somewhat strong/strong pairing in EUR/USD.
But in mid-2005, the UK was facing a host of problems including the housing bubble, rising inflation, and slowing economic growth, and the Bank of England (BOE) hinted that it was considering cutting interest rates. This possible rate-cutting signaled a move in the opposite direction of both the Fed and the ECB. This created a weak/strong pairing in GBP/USD versus the strong/strong pairing in EUR/USD. That means GBP weakness would be more pronounced against USD than EUR against USD, and we would capture more gains when shorting GBP/USD than EUR/USD. Let's look at the charts.
Return to December 2006 ContentsOriginally published in the December 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved.
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