Cross-Currency Pairs – How are they Traded?
Cross-currency pairs trading means trading two non-U.S. dollar currencies against each other. Unlike the major currency pairs, these do not include the USD. This often results in different trading dynamics and liquidity scenarios. They offer opportunities to capitalize on the economic interactions between other major economies.
How Cross-Currency Pairs are Traded?
Trading cross-currency includes calculating cross rates, which are not directly quoted in the market. For instance, a trader might use the EUR/USD and AUD/USD rates to find the EUR/AUD rate. They can determine the EUR/AUD cross rate by dividing the EUR/USD rate by the AUD/USD rate. This requires understanding the currencies’ direct and indirect quotes.
Benefits of Trading Cross-Currency Pairs
Diversification Benefits
Investors can reduce their reliance on the U.S. dollar, minimize the impact of U.S. economic news on their portfolios, engage in trade based on the comparative economic developments of other countries, and diversify their trading strategies and risks.
Access to Less Competitive Markets
They typically face less market competition compared to major currency pairs. It means fewer market participants, which may result in less price manipulation and cleaner technical setups. It also gives opportunities to capitalize on unique economic events that do not directly involve the U.S. economy.
Balanced Exposure
Trading numerous pairs enables traders to spread their exposure across multiple economies. This allows them to balance potential losses in one region with gains in another.
Price Discrepancy Benefits
They sometimes offer opportunities to benefit from price discrepancies between different markets. For instance, if currency pairs are not aligned in price equivalently across different markets, a trader can buy the undervalued pair in one market and sell the overvalued pair in another.
Challenges in Trading Cross-Currency Pairs
Despite all the benefits, they also come with inherent risks:
Liquidity Issues
Cross-currency are less popular than major pairs and have lower trading volumes. It can result in higher bid-ask spreads, making entering and exiting trades more expensive. Also, orders might not be filled at anticipated prices, affecting profitability and trading strategy execution.
Impact on Trading Strategies
The volatility in less liquid pairs shows sudden and sharp price movements. It requires higher risk tolerance and more vigilant risk management measures.
Multiple Economies Interaction
When trading minor currency pairs, traders must understand the economic fundamentals and interactions of two separate economies. This complexity requires keeping up with more economic indicators and political events that may influence each currency differently.
Indirect Influences
Economic or political developments in countries indirectly related to the cross-currency pair can influence price movements. For example, a commodity price change in a third country could affect a currency pair like AUD/CAD and complicate the trading strategy.
Conclusion
Trading cross-currency pairs offers opportunities for diversification and access to different economic relationships. However, it requires understanding complex economic interactions and tailored trading strategies due to the inherent risks of lower liquidity and higher volatility. Traders must start with demo accounts or small positions to understand market behaviour without significant risk.
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