Why Diversifying Currency Pairs Matters in Forex Trading!

Forex trading, being a highly volatile market, undergoes rapid changes in currency exchange values. As a forex trader, seeking smoother and less risky trading sessions becomes imperative. This is where effective forex portfolio diversification plays a vital role.

Trading only one currency pair is like limiting yourself to a single note in the symphony of global economic opportunities.

Diversification holds immense significance in forex trading as it helps mitigate risk exposure. By trading different currency pairs, the risk is spread across diverse markets. Consequently, if one asset line experiences a decline, the presence of other assets can provide cover and reduce the impact of potential losses, regardless of their magnitude.

Moreover, the forex market offers distinct advantages compared to other asset types, presenting traders with ample opportunities for substantial gains. Additionally, forex traders have the flexibility to switch between various asset classes, swiftly adapting to diverse market conditions. This not only fosters financial prosperity but also contributes to emotional and physical stability.

Beyond the USD: Exploring the World of Cross Currency Pairs

Traders can gain several advantages by extending their forex trading beyond the USD and focusing on cross-currency pairs.

Since these pairs also involve major currencies from different countries, they offer distinct advantages, as outlined below:

• Increased Trading Opportunities: The vast forex market offers numerous cross currency pairs for trading. Embracing these pairs broadens the scope of options, enabling traders to discover setups and strategies that may not be present when focusing solely on major USD pairs.

• Diversification: By incorporating cross currency pairs into their forex portfolio, traders achieve diversification. Unlike traditional forex trading, which often involves pairs quoted against the USD, cross currency trading reduces reliance on the USD and allows exposure to a wider range of global currencies, effectively spreading the risk.

• Lesser Spreads and Costs: In certain cases, cross currency pairs may offer narrower spreads compared to USD pairs. This translates to reduced trading costs for forex traders, making it potentially more cost-effective to execute trades.

• Avoiding USD Volatility: Significant global events and economic news can greatly impact the USD, resulting in heightened volatility for USD-denominated pairs. Trading cross currency pairs allows traders to potentially avoid some of this volatility caused by USD-related news, enabling a focus on the individual strength and weaknesses of the currencies involved.

• Better Reflecting Global Economic Conditions: Cross currency pairs provide a more accurate representation of economic conditions between two specific countries. In contrast, trading USD pairs may be influenced by factors related to the US economy, even if they arent directly relevant to the other currency in the pair. Cross currency pairs enable traders to analyze and capitalize on the economic performance of both countries involved.

• Currency-Specific Trading Opportunities: Trading cross currency pairs presents unique opportunities based on specific events or developments within the two countries involved. Economic data releases or geopolitical events that impact one currency more than the other can lead to favorable trading scenarios.

• Hedging Possibilities: Cross currency pairs are often used for forex hedging purposes. For businesses exposed to multiple currencies, trading cross pairs allows for more efficient management of exchange rate risk.

Remember, when constructing a well-diversified investment portfolio, the more uncorrelated pairs you use, the more likely it is you will outperform the benchmark. As long as the pairs selected are not highly correlated, each component of the portfolio will move independently, reducing overall risk.

5 Best Forex Currency Pairs to Trade Beyond USD!

Here are ten popular forex currency cross pairs, in no particular order, that are worth considering:

1. EUR/GBP (Euro vs. British Pound):

The EUR/GBP currency pair signifies the exchange rate between the Euro, the common currency for the Eurozone, and the British Pound Sterling, the official currency of the United Kingdom. It holds significant popularity in the global financial market due to its high liquidity and active trading. Engaging in trading activities involving the EUR/GBP currency pair offers several advantages:

• High Liquidity: The EUR/GBP pair provides exceptional liquidity, allowing traders to easily enter and exit positions with a narrow bid-ask spread.

• Volatility Opportunities: The EUR/GBP pair tends to be most active from 06:00 to 16:00 (GMT), presenting prime trading times with increased forex volatility. On average, it experienced 64 pips of volatility per day in 2019.

• Lower Spreads: As a ‘cross pair’ without the involvement of the USD and classified under the ‘minors’ group in the forex market, the EUR/GBP enjoys lower spreads compared to exotic currency pairs.

• Profit Potential: The EUR/GBP is known for its profitability, allowing traders to minimize trading costs and achieve higher gains when the pair moves favorably.

• Diversification Benefits: Trading the EUR/GBP enables diversification of portfolios, reducing overall risk exposure for traders with heavy exposure to other currencies.

Find out how liquid assets add value to your investment portfolio!

2. EUR/JPY (Euro vs. Japanese Yen):

The EUR/JPY forex currency pairs compare the Euro against the Japanese Yen, and they hold considerable popularity among traders for several reasons:

• Volatility: The EUR/JPY pair is well-known for its high level of volatility, which offers traders numerous trading opportunities.

• Japanese Influence: Trade relations between Japan and the Eurozone play a crucial role in the EUR/JPY exchange rate. This pair is affected by factors like Japanese imports and exports, as well as the strength of the Japanese economy.

• Liquidity: Approximately 3% of all daily transactions take place for this currency pair, making it the seventh most liquid in the market.

• Leading Indicator: The EUR/JPY pair provides traders with insights into the overall market direction as a leading indicator for stocks.

• Technical Analysis: Market participants are able to analyze and trade the EUR/JPY pair using a variety of technical analysis tools and strategies.

3. GBP/JPY (British Pound vs. Japanese Yen):

Known as “Geppy,” the GBP/JPY forex currency pairs combine the economic factors of the UK and Japan, making it a good trading option.

• Carry Trade Strategy: GBP/JPY is frequently used in carry trade strategy, which involves borrowing funds in one currency and investing in another. There is potential for profit-making between British Pounds and Japanese yen due to their interest rate differences.

• Liquidity: The GBP/JPY pair is a popular currency pair worldwide due to its liquidity and widespread availability. Due to this, traders can enter and exit positions easily without experiencing considerable price slippage.

• Diversification: Trading GBP/JPY will result in portfolio diversification advantages. Forex traders can minimize the impact of unfavorable market movements by diversifying their currency pairs.

• Volatility: The GBP/JPY exchange rate exhibits a high level of volatility, which results in significant changes in price. A characteristic like this can be beneficial to traders who are looking to take advantage of short-term or medium-term price movements.

• Correlation Opportunities: Trading the GBP/JPY currency pairs involves understanding currency correlations. It is possible that GBP/JPY shows a correlation with other currency pairs such as GBP/USD and USD/JPY. By analyzing forex correlations, traders can gain insights into possible trading opportunities.

4. EUR/CHF (Euro vs. Swiss Franc):

The EUR/CHF forex currency pair, also known as the “Swissy,” demonstrates the relationship between the Euro and the Swiss Franc, providing stability owing to Switzerlands reputation as a safe-haven currency.

• Closely-Tied Economies: EUR/CHF involves two closely-tied economies in competition — the Swiss economy versus the eurozone. Economic events in one country can significantly impact the other, creating favorable trading opportunities for forex traders.

• Correlation: According to a survey, there exists a robust correlation of 92.7% between the euro and the Swiss franc currency pairs. This implies that when the euro strengthens, the Swiss franc tends to weaken, and vice versa, offering potential trading opportunities for forex traders.

• Stability: Considered one of the most stable currency pairs in the forex market, EUR/CHF owes its stability to Switzerlands safe-haven status. During times of economic uncertainty, investors often turn to the Swiss franc as a secure haven for their capital.

• Low Volatility: EUR/CHF is generally recognized as a low-volatility currency pair. Compared to more volatile currency pairs, it presents a potentially lower risk when trading.

5. AUD/JPY (Australian Dollar vs. Japanese Yen):

AUD/JPY is a currency pair consisting of the Australian Dollar and the Japanese Yen. Trading this pair is popular among traders seeking exposure to Asian-Pacific and Japanese markets due to its high volatility. This pair may also appeal to traders for these reasons:

• Volatility: AUD/JPY prices fluctuate significantly, presenting traders with opportunities to profit from price movements.

• Interest Rate Differential: Japan has historically maintained lower interest rates than Australia. The interest rate differential opens doors for carry trades, in which traders borrow in the low-yielding JPY and invest in the high-yielding AUD.

• Close Economic Relationship: Japan and Australia have a close economic relationship. Both countries economies can affect the currency pair, making it a popular market among traders who closely follow economic data and news.

• Diversification: AUD/JPY trading can diversify portfolios, especially for traders who already have exposure to other major currencies, like USD/EUR. Diving into different currency markets can reduce risk.

• Commodity Price Sensitivity: Japan heavily relies on Australian commodities as a major exporter of commodities. Therefore, fluctuations in commodity prices may result in significant fluctuations in AUD/JPY, creating trading opportunities.

In case you do not feel comfortable investing in any of the five forex currency pairs listed above, check out the inter-market correlations!

Its cool to look at Inter-Market Correlations, too!

Intermarket correlations in forex trading encompass the connections between various financial markets and their mutual influence. Comprehending these correlations proves invaluable to forex traders, empowering them to make well-informed decisions and manage risks effectively.

Inter-market correlations act as the invisible threads connecting global financial markets, dictating the ebb and flow of forex price actions.

Below are several types of inter-market correlations commonly observed in forex trading:

Forex & Commodities Correlations:

Positive correlation between Gold and AUD/USD due to Australias gold production and the Aussie being a “commodity currency.” Swiss Franc (CHF) strengthens with rising gold prices due to significant gold reserves. Silver may also influence AUD/USD.

West Texas Intermediate (WTI) crude oil affects USD/CAD as Canada is a major oil exporter. Oil prices impact CAD and JPY, benefiting Japan as a net importer. Brent Crude Oil affects USD/NOK, and Norways economy heavily relies on oil exports.

Forex & Stocks Correlations:

Currency pairs and the U.S. stock market generally display a positive correlation, indicating the robustness of the U.S. economy. However, some exceptions exist, especially with blue-chip indices like the DJIA. Companies in such indices with significant overseas operations may experience a negative impact on their stock prices due to fluctuations in the U.S. dollar.

On the other hand, certain market indices exhibit stronger correlations with specific currency pairs, like the S&P 500 and USD/JPY. Taking advantage of these correlations requires analyzing a companys foreign exchange exposure thoroughly.

Forex & Bonds Correlations:

The bond market and foreign exchange market are closely connected, with bond prices often indicating currency movements. Monitoring government bond prices is crucial for predicting currency price changes. Bond prices and bond yields have an inverse relationship: when bond prices rise, bond yields fall, and vice versa. Government bonds are generally considered safer investments, resulting in lower yields. However, this can vary depending on the country. For example, stable countries like the United States have lower bond yields compared to less stable countries like Argentina.

Learn How does Stock Market Volatility Impact Forex Trading？

The effectiveness of risk diversification largely depends on understanding these correlations, making it a crucial strategy when investing in the highly liquid forex market. However, it's important to avoid over-diversification, as an improper understanding of correlations may lead to suboptimal outcomes. Traders who can strike the right balance in interpreting intermarket correlations gain a significant edge when trading forex.

Disclaimer: This post is from Aximdaily and it is considered a marketing publication and does not constitute investment advice or research. Its content represents the general views of our editors and does not consider individual readers personal circumstances, investment experience, or current financial situation.