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Trading Strategies

Posted By Robert On Friday, January 20th, 2012 With 0 Comments

How do currencies differ in spreads and liquidity?

Not all currencies are created equal. EUR/USD and USD/JPY are the two most liquid pairs with the best spreads in the markets. This has to do with the fact that they represent the two largest cross border trade and investment flow relationships in the world. This gives banks a lot of non-correlated forex flows from a lot of non-speculative clients, allowing them to offer a lot of liquidity. That’s why EUR/JPY, which is a cross of both, is also fairly liquid and tight. These three currency pairs have high levels of liquidity 24 hours a day. GBP and CHF crosses on the other hand are not as liquid and tend to have the majority of their activity during European business hours. When liquidity in a pair is low, bid/offer spreads tend to be wider and the amounts attached to those bids and offers are lower. The minor currency pairs AUD/USD and AUD/JPY tend to be fairly tight and liquid 24 hours a day† and have shown better consistency then GBP/USD and GBP/JPY in recent years. NZD and CAD crosses tend to be less liquid than GBP pairs. Beyond these currencies, Scandinavian and emerging market currencies can be thought of similarly to equities, basically fitting into one time zone and with an overnight market with wide spreads and low liquidity.

Are all currency pairs created equal and how does this affect my trading?

1) EUR/USD:

The most liquid pair in the world with the tightest prices. Most bank market makers are excellent at providing this pair, which we believe makes it a no brainer when trading at a No Dealing Desk broker like FXCM. Liquidity is good and deep 24 hours a day†. It’s the best currency pair for doing large trades, as well as the best currency to scalp during Asian hours because of the low spreads. Most high frequency institutional systems that go for a few pips per trade generally use EUR/USD.

2) EUR/JPY:

A highly liquid pair with similar characteristics to the USD/JPY. This one happens to have better defined trends and is more volatile due to the concentration of speculators. EUR/JPY is a great currency pair for breakout, momentum and other typical technical strategies.

3) USD/JPY:

Another liquid currency pair that’s almost as good as the EUR/USD, but with slightly less consistent spreads. This is another great pair to scalp on low spreads. UAD/JPY tends to be a safer currency pair to scalp or range trade since it’s less volatile on an intraday basis than the EUR/USD. This is another currency pair that is widely used by high frequency systems.

4) GBP/USD:

After the euro, this is the most popular currency pair to trade. It’s volatile intraday and long term. This pair is not as liquid as the EUR/USD and USD/JPY; thus, it usually has a higher spread than EUR/USD or USD/JPY. The London session is best for trading GBP/USD. During Asian hours, GBP/USD is hard to trade in large size because liquidity is lower and spreads become inconsistent. GBP/USD is the most common pair for beginners to lose money in. Range trading strategies are not recommended, nor is scalping. GBP/USD, just like GBP/JPY, is a great breakout and momentum currency. Dealing desks usually do a good job in GBP/USD during the Asia session as they understand that GBP/USD trading is where many people lose money, so dealers are willing to offer fixed spreads or tighter spreads during this time. However, when this currency pair does move, usually during London session, orders in GBP/USD are heavily re-quoted by dealing desks, thus offsetting the initial advantage of fixed or tight spreads during the Asia session.

5) GBP/JPY:

This is one of the most volatile currency pairs and the favourite currency pair of the retail forex trading community. Just like GBP/USD, it’s a pair that has left massive customer losses in its wake and requires iron discipline to trade. Liquidity and spreads vary widely as it is a synthetic pair created from the GBP/USD and the USD/JPY. Range trading should not even be attempted and only momentum and/or breakout trading should be tried as strategies. Traditional retail forex dealing desks love this pair, since many clients blow up here. Dealing desks will usually provide good spreads in this pair to attract traders. GBP/JPY is a volatile pair, so when news does break this is also a pair dealing desks tend to heavily re-quote.

6) AUD/USD:

A great currency pair to trade 24 hours per day.† Australia’s business day is the same as much of east Asia. This ensures there is activity in AUD pairs during Asian hours, so spreads remain fairly tight.

7) USD/CAD:

Liquidity is greatest in the North American time zones due to cross border investment and trade (US and Canada are each other’s largest in both respects). Outside of this time, spreads are wider and liquidity is lower. USD/CAD is used for macro bets on oil and tends to have good trends on a long term basis.

8) NZD/USD:

A much smaller economy and currency means that, although similar to Australia, spreads are wider and there is less liquidity. In most years, interest rates are higher than most other developed economies, and people often trade NZD crosses for the carry.

9) EUR/CHF:

This pair is noted for its low intraday ranges. It’s a perfect pair for range trading strategies and scalping. Liquidity and spreads in the European and North American time zones are excellent. Liquidity and spreads tend to deteriorate significantly during Asian hours.

10) EUR/GBP:

This pair is very similar to EUR/CHF, with low intraday ranges. There tends to be great liquidity and spreads during European and US markets. During the Asian session, spreads widen and liquidity is significantly lower.

11) Other yen crosses:

The yen is the world’s most consistently borrowed currency for carry trade purposes. Most yen crosses are, therefore, used for their carry potential. USD/JPY, EUR/JPY and AUD/JPY tend to have good spread, while other crosses have fairly wide fluctuations and are usually good for macro bets, breakout and momentum trading. Many people range trade them at times but overall these are trending currencies.

12) Emerging market currencies:

These should be traded only in their respective time zone and be thought of as longer term macro bets on the particular country and/or commodity. Wide spreads won’t allow for scalping and it’s very hard to trade large sizes in short periods of time. It’s better to scale into it. Overnight markets for these are thin if they exist at all, so strategies must use lower leverage to avoid needing to exit overnight due to a margin call.

13) Scandinavian currencies:

These should be thought of in the same way as emerging market currencies. Scandinavian economies are rather stable, so the risks are smaller than emerging market currencies.

Which time zones are best for trading currencies?

The answer depends on what strategy and what currency pairs you are trading. The London session, essentially from 3 a.m. to noon ET, is the time where most forex trading takes place. Spreads are the tightest and liquidity is the deepest. It is also a time when the market makes the majority of its moves. For GBP and CHF traders, we believe this is when trading should be done. For EUR and JPY traders, trading at any time is ok. Range traders may want to consider the Asia session, as markets don’t move as much and it’s less likely that a range trading strategy will get caught in a large move.

What challenges does the Asian trading session present?

The Asian time zone presents challenges and opportunities in forex. Liquidity is much lower than the rest of the day, and there are fewer banks, market makers and institutions in the market during this time. This is not the time to place very large orders, nor is it recommended to trade GBP or CHF crosses. EUR and JPY crosses tend to be fairly liquid and spreads are usually relatively good. AUD and NZD pairs are also good since it’s their business day.

Why do certain pairs have better spreads and liquidity than others?

This question has a few very important components:

A) The Size of a country’s trade flows and financial markets:

The US dollar is backed by the world’s single largest economy as well as its largest financial markets. The dollar is also used as a reserve currency by nearly every other country on earth. The euro is a currency used by 17 European countries, including three of the seven largest economies in the world. The yen is used by the world’s third largest economy. As you go down the list and get to smaller economies, the amounts of cross border transactions and financial flows shrink dramatically. That’s why you see higher spreads and less liquidity.

B) Natural currency pairs versus synthetic crosses:

Natural currency pairs are pairs where there is a real market of buyers and sellers exchanging the two currencies directly. Synthetic currency cross rates are currency pairs where there isn’t enough natural demand for a dedicated market in that pair. Banks calculate synthetic crosses from the two underlying pairs. The US dollar, against all freely available currencies, makes the most common natural pairs. The euro is a natural pair only against JPY and its neighbours the GBP, CHF, Scandinavian currencies, and eastern European currencies. The yen is a natural currency only against the euro and the dollar. GBY/JPY is a synthetic pair where the price is really composed from a GBP/USD pair and a USD/JPY pair. This makes it more dangerous to be a market maker since the calculation time adds to latency as well as the execution risk in hedging the legs of the trade. This naturally makes banks take a more cautious approach to quoting these pairs, depending on how well trading is going. Retail dealing desks don’t have such issues as they don’t need to pass orders to the real market. As long as clients aren’t profitable, especially in shorter term strategies, the dealing desk will quote aggressively, but that won’t continue if customers start to really make money from it.

C) Non-correlated flows:

Flows of money due to trade and cross border investments make up a large part of currency trading in certain pairs. EUR/USD, USD/JPY and EUR/JPY are the three most liquid to trade because of the existence of so much of these non-correlated flows. EUR/GBP and EUR/CHF enjoy this as well during the European trading session. The less trade and investment flows are in a currency pair the more it’s dominated by speculators. That means that market makers are more defensive, which means providing wider spreads and less liquidity.

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