Choosing the right currency pair is significant in the forex market as it can directly influence a trade’s outcome, gains, risk exposure, and overall trading strategy effectiveness.
In this article, we dive deeper into how to choose the forex pairs.
What are forex currency pairs?
Forex currency pairs are combinations of two currencies used in forex trading, where one currency is bought while the other is sold. The exchange rate represents how much of the second currency is needed to purchase one unit of the first.
The base currency is the first currency listed in the pair and is the currency one is trading. The quote currency is the second currency and represents the value of the base currency in terms of the quote currency. For example, in the EUR/USD pair, EUR is the base currency, and USD is the quote currency.
Types of forex pairs
Major pairs
Major currency pairs include the most widely recognized and highly traded currencies in the world, always featuring the US Dollar (USD). They are considered major because they typically represent strong and stable economies. Traders prefer major pairs because they offer high liquidity, meaning one can trade them easily and with minimal price fluctuations.
Major pairs also offer lower spreads (the difference between the bid and ask prices), which makes trading major pairs cost-effective. Examples include EUR/USD , USD/JPY, and GBP/USD.
Minor Pairs (cross-currency pairs)
Minor currency pairs, or cross-currency pairs, do not include the US Dollar. Instead, they involve two other major currencies from different countries. While they may have lower trading volumes and slightly wider spreads than major pairs, they are still actively traded in the forex market. Traders often use minor pairs to diversify their portfolios and look beyond the US Dollar's influence
Examples include EUR/GBP, EUR/AUD, and GBP/JPY.
Exotic pairs
Exotic currency pairs combine one major currency with one from a smaller or emerging market economy. They are less frequently traded pairs, often exhibiting wider spreads, reduced liquidity, and higher volatility, compared to major and minor pairs.
Traders interested in exotic pairs should have a higher risk tolerance and a deep understanding of the specific economic and political factors influencing the countries in question. Examples include USD/TRY, EUR/THB, and GBP/ZAR.
Factors influencing pair selection
Trading goals and objectives
A trader's trading goals and objectives play a pivotal role in determining the choice of currency pairs. Different pairs align better with various trading strategies and objectives. If the goal is short-term gains through day trading, traders may prefer highly liquid major currency pairs that offer frequent trading opportunities, such as USD/EUR.
On the other hand, if traders are long-term investors aiming for capital preservation and stability, they might opt for less volatile pairs, such as major pairs, or even minor pairs, such as EUR/AUD. Trader's goals should drive their pair selection, as different pairs have different risk and reward profiles.
Risk tolerance
Forex trading can be highly volatile, and the choice of currency pairs should match the trader's risk appetite. Major pairs are generally considered lower risk due to their stability and liquidity, making them suitable for traders with lower risk tolerance. In contrast, exotic pairs are often associated with higher risk and volatility. If the trader has a higher risk tolerance and is willing to accept more significant price fluctuations, they might consider trading exotic pairs or other higher-risk options.
Market conditions and volatility
Market conditions and volatility levels at any given time can strongly influence the pair selection. During periods of high market volatility, such as economic events, geopolitical tensions, or significant news releases, some currency pairs may experience more substantial price swings.
Traders seeking volatility and short-term gain opportunities may be drawn to these situations and opt for pairs that are currently active and experiencing price movements. Conversely, in calmer market conditions, traders with a preference for stability may gravitate toward less volatile major currency pairs.
Pros and cons of pairs trading
Pros of forex pair trading:
- Variety of tradable pairs: Forex markets offer various currency pairs, including major, minor, and exotic pairs. This variety allows traders to choose pairs that align with their trading strategies and market conditions.
- Long and short opportunities: Pair trading enables traders to gain from both rising and falling markets. Traders can go long on one currency while simultaneously going short on another, potentially generating gains in any market direction.
- Managing drawdowns: A drawdown in trading is the reduction in the value of a trading account from its peak to a subsequent low before it begins to recover. Pair trading can help manage this portfolio risk. By trading two correlated or inversely correlated currency pairs simultaneously, traders can reduce exposure to market movements and limit potential drawdowns, making it a risk management tool.
- Flexible trading hours: Forex markets operate 24 hours a day, five days a week, allowing traders to choose pairs per the trading hours that suit their schedules and preferences. This flexibility is particularly useful for traders in different time zones.
Cons of forex pair trading:
- High risk: Forex pair trading can be high-risk, especially when trading exotic or highly correlated pairs. The market's volatility, leverage, and the potential for sharp price movements can lead to substantial losses.
- Complexity: Pair trading requires a strong understanding of currency correlations, technical and fundamental analysis, and market dynamics. It can be complex for beginners and demands continuous learning and monitoring.
- Emotional stress: Forex pair trading can be emotionally taxing and emotional decision-making can lead to impulsive trades and losses. Staying disciplined and managing emotions is a significant challenge for many traders.
- Costs: Trading forex pairs can entail costs, including spreads, commissions, and overnight financing charges. These costs can add up and affect the gain of trades, particularly for frequent traders.
- Lack of guarantees: There are no guarantees of gains in forex pair trading. Markets can be unpredictable, and even well-researched trades can result in losses. Traders must be prepared for the possibility of unsuccessful trades.
Top forex pair trading strategies
Arbitrage strategy
Arbitrage trading strategy capitalizes on price discrepancies of the same currency pair on different exchanges or brokers. Traders quickly purchase at the lower price and exit positions at the higher price to make a risk-free gain. This strategy requires advanced technology, fast execution, and continuous monitoring. While it carries low risk, the gains are typically small, and margins can be slim. Arbitrage often depends on high-frequency trading algorithms and precision in execution.
Hedging strategy
Hedging is a risk management strategy that involves taking opposite positions in correlated currency pairs to reduce potential losses. For instance, if a trader is long in one pair, they may go short in another pair to offset potential losses. Hedging is typically used to protect an existing portfolio or position. While it reduces risk exposure, it can also limit gain potential if both the hedges and primary positions move against the trader. Additionally, it can be costly due to spreads and trading fees.
Correlation trading
Correlation trading focuses on analyzing the relationship between different currency pairs. Traders look for pairs that tend to move together (positive correlation) or in opposite directions (negative correlation) and make trading decisions based on these correlations. The strategy provides opportunities to diversify trades and reduce risk. However, correlations may change over time, leading to unexpected price movements. Not all correlations are stable or reliable.
News trading
News trading is a short-term strategy to gain from significant price movements following economic events or news releases. Traders analyze economic calendars and react quickly to news events. It offers short-term gain opportunities with substantial price swings but is highly volatile and risky. Slippage and rapid market movements can lead to losses. The right news trading process requires precise timing and effective risk management.
Carry trade strategy
Carry trade is a strategy that involves borrowing funds in a currency with a low-interest rate (the funding currency) and investing in a currency with a higher interest rate (the target currency). Traders aim to gain from the interest rate differential. This strategy provides passive income through interest differentials and potential capital gains. However, it also carries the risk of currency depreciation, which can offset interest gains. Carry trades are vulnerable to sudden market shifts and economic events that can impact exchange rates.
Tips for choosing forex pairs
- Consider currency pair correlations: When choosing forex pairs, it is essential to consider currency pair correlations. Some currency pairs move in the same direction (positive correlation), while others move in opposite directions (negative correlation). Understanding these correlations can help manage risk and diversify portfolios effectively.
- Stay updated with the economic calendar: Staying informed about economic events and news releases is crucial when selecting forex pairs. Economic data, central bank decisions, and geopolitical events drive many currency movements. Regularly checking an economic calendar can anticipate potential market-moving events and plan the trades accordingly. For example, if a central bank is scheduled to announce an interest rate decision, it can significantly impact currency pairs involving that currency.
- Diversify with cross-currency pairs: Cross-currency pairs, also known as minor pairs, exclude the US Dollar (USD) and involve two other major currencies. Trading cross-currency pairs can provide diversification in their portfolio, reducing the reliance on the USD. Events can lessen their influence in the United States and offer unique trading opportunities. Diversifying across different regions and economies can help spread risk and provide trading flexibility.
- Practice on a demo account for specific pairs: Before committing to real capital, it is advisable to practice trading specific currency pairs on a demo account. Demo accounts allow traders to familiarize themselves with the characteristics and price movements of the interested pairs. They can develop and refine their trading strategies, test risk management skills, and understand how specific pairs behave in various market conditions. This practice gives traders valuable experience and confidence when trading real money.
How to choose the right forex pair for trading
Establishing clear trading goals
Before selecting a forex pair, the trader should establish their trading goals. Their goals will influence their choice of pairs, such as whether they aim for short-term gains, long-term stability, or a combination of both. For instance, they may prefer less volatile major pairs if their goal is capital preservation.
Assessing risk tolerance
The trader should consider their risk tolerance when choosing currency pairs. If the trader has a lower risk tolerance, major pairs with more stability and liquidity may be their preference. Traders with a higher risk tolerance may explore options such as exotic pairs or volatile minor pairs.
Analyzing market conditions
The trader should carefully analyze market conditions and trends. Different currency pairs may perform better in various economic or geopolitical situations. For example, less risky currencies like the US Dollar may be selected during periods of economic uncertainty.
Evaluating currency pair correlations
The trader should examine currency pair correlations to diversify their portfolio and manage risk. Understanding how different pairs move in relation to each other can help in making informed decisions regarding pairs that complement or offset each other.
Factoring in interest rate differentials
Interest rate differentials can affect the attractiveness of currency pairs. The trader should choose pairs based on the potential to gain from interest rate disparities. For example, a trader interested in earning interest income might seek to carry trade opportunities.
Regularly monitoring and adapting
Forex markets are dynamic and constantly changing. Traders should continuously monitor the pairs they're trading and be ready to adapt their strategy based on changing market conditions and their evolving trading goals.
The consequence of choosing the right forex pair
Selecting the right forex pair plays a crucial role in effective risk management. Different currency pairs exhibit varying levels of volatility, and by selecting pairs that align with your risk tolerance, traders can minimize the potential for unexpected and unfavorable price swings, ultimately preserving their capital. However, it's important to remember that even with careful pair selection, there are inherent risks in forex trading. The market can be unpredictable, and unforeseen events can lead to unexpected price fluctuations.
Armed with a deep understanding of your chosen pairs, traders can better anticipate price movements, implement effective entry and exit points, and make well-informed trading choices that enhance their overall trading performance and profitability. While careful pair selection can mitigate some risks, it's crucial to acknowledge that no strategy can eliminate all uncertainties in the forex market. Therefore, always be prepared for the unexpected and exercise prudent risk management practices. Ultimately, it leads to making more informed decisions in the forex market.
