Cross currency pairs: forex trading without US dollars
11:34, 2 June 2017
Cross currencies are currency ‘pairs’ that omit the US dollar - the bulk of global exchange rate transactions involve the US currency or ‘greenback’. Cross currencies are where other currencies are allowed to be the dealmaker.
Buying and selling cross currencies provides an opportunity for bigger currency swings. That’s because currency pairs not twinned to the US dollar can fluctuate by greater extremes.
Traders can trade weaker economies against stronger ones. So there is potential for greater profits, as well as greater losses. Cross currency trading is also highly useful for hedging purposes.
- Cross currencies are about major currencies not measured against the US dollar, for example the pound/yen, GBP/JPY or the euro/Swiss franc, EUR/CHF
- The first currency, left, is ‘the base’ currency, the second currency, on the right, is ‘the quote’
- Interest rates are a key part of currency moves
Costs
The spread costs are wider on cross currencies. That’s because costs depend on how actively a currency pair is traded – basic supply and demand.
When you trade different currencies you have the sell price (or bid) and the buy (or ask) price. The difference between the two is the spread – the cost of placing that trade.
Currency moves are measured in pips. Most major currencies are quoted to the fourth or sometimes fifth (even sixth) decimal place. If you were to look at, say, a EUR/GBP spread you might see a sell/bid price of 0.8486 with a buy/ask price of 0.8487 (late April 2017).
That’s a spread of one pip. In this example, one euro is worth 85 pence.
The small spread tells you how ‘liquid’ – how easy it is to buy and sell – a particular currency pair is.
If you were looking at sterling versus yen you might see GBP/JPY with a sell/bid price of 142.73 and a buy/ask price of perhaps 142.76 (late April 2017).
That’s a wider three-pip spread (the spread against the Japanese yen is usually quoted only to two decimal points). On some less ‘liquid’ currencies the pip spread can be as much at 10.
When you buy currencies you are effectively buying one currency and selling another.Diversification and strategy
Like buying shares in the stock market where you’ve an abundance of choice, cross currencies offer wide diversification.
Longer term it’s a good idea to have exposure to several currency pairs so it allows you to understand how the currencies respond to each other from economic or political news.
When you buy currencies you are effectively buying one currency and selling another. If you live in the UK and you buy dollars you are buying the US dollar at the same time you are selling sterling.
Effectively, that’s two transactions rather than one – though the price transaction is treated as one. This compares with buying shares on the stock market where you might only buy one stock – there is no immediate pairing with other stocks.
Bear in mind all cross currencies still respond to the US dollar, even if you are buying other currencies. Successful currency cross trading is often aided by good fundamental analysis.
In other words, look at a currency in relation to financial and economic factors such as interest rates, commodity exposure (gold, oil, etc), employment data and sovereign debt levels.
So a firm grasp of the economies of both currencies is vital as well as an appreciation of ‘safe haven’ issues. That is, how (and which) currencies are likely to withstand market downturns.
Handling (considerable) risk
While making a cross pair trade is straightforward, selling can be riskier. That’s because when you exit, your profit (or loss) may be in a currency that is not your own home currency.
For example, if your home currency is sterling and you have a successful cross EUR/JPY trade, you still need to trade that profit back into pounds.
Cross rate trading is closely linked to speculation. It carries multiple risks – political, economic and environmental. Many investors lost money when the Swiss National Bank scrapped the link between the euro and Swiss franc in early 2015.
Similarly, Britain’s pro-Brexit vote on 23 June 2016 saw huge currency swings for GBP/EUR and GBP/USD.
Going further back, there were big losses with the Thai bhat in 1997. Up to that point the Thai government had pegged its currency to the yen and dollar. Lacking the necessary currency reserves the Thais were forced to float the baht.
This precipitated the Asian financial crisis that consequently ripped through South Korea and Indonesia.
So, handling all the risk factors should be your number one priority.
Summing up
Do remember that in any cross currency trade you need to evaluate not just one country’s economic and political situation but two – perhaps even several if you’re hoping to benefit from regional imbalances.
Your risk is amplified when using minor and exotic currency pairs, typically from developing areas such as Africa, the Middle East and South America.
Be aware that some brokers may charge you higher spreads if you’re trading at certain times of the day where there’s weaker liquidity in other time zones – Asia or South America for example.
In any cross currency trade you need to evaluate at least two countries economic and political situation.Major currency cross pairs – the most liquid examples
- EUR/CHF – Euro/Swiss franc
- EUR/GBP – Euro/sterling
- EUR/JPY – Euro/Japanese yen
- GBP/JPY – Sterling/Japanese yen
Minor ‘crosses’ include
- AUD/CHF – Australian dollar/Swiss franc
- AUD/JPY – Australian dollar/Japanese yen
- CHF/JPY – Swiss franc/Japanese yen
- EUR/CAD – Euro/Canadian dollar
- GBP/AUD – Sterling/Australian dollar
- NZD/JPY – New Zealand dollar/Japanese yen
Exotic currency pairs examples – handle with huge care
- IQD/QAR – Iraqi dinar/Quatari rial
- LBP/ILS – Lebanese pound/Israeli shekel
- PLN/RUB – Polish Zloty/Russian ruble
- HUF/EEK – Hungarian forint/Estonian