Newcomers to the world of forex trading are often taught how to focus on one to three currency pairs in the market. The goal is for you to become familiar with the nuances of a few specific pairs and then focus your trading strategy accordingly. The first recommendation is always “EUR/USD”, which, according to the Bank for International Settlements (BIS), is the most traded currency pair.
This pairing represents 30% of trades in the market. In fact, the US dollar participates in 50% of daily foreign exchange transactions. Stability, liquidity and tight spreads are the main attractions of USD pairs, but what about other currency pairs that do not include the USD? These pairs have been given a special name – Forex Cross Pairs. Many of these pairs have great liquidity in today’s modern Forex market and are referred to as major cross pairs. As you might expect, there are also small and exotic sub-pairs of forex.
In this article, you will learn about the history of cross currency pairs, which are the most popular, and which traders find best to trade on a cost-effective and opportunity basis. As in trading major and minor USD pairs, you still need an edge, but you will be free of the rather large “hammer” that the Fed can use on the market or inflated reactions to anything that happens in the US economy.
What are cross currency pairs?
The simple definition of a forex pair is any pairing of a currency with any other currency except the US dollar. This idea dates back to after World War II and long before currencies began floating in real market conditions in the 1970s. After the war, the United States became the most stable economic country because it was not destroyed by war. For this reason, almost all currencies are pegged to the US dollar.
If you need to convert British Pounds to Japanese Yen, the process involves first converting British Pounds to US Dollars and then converting US Dollars to Japanese Yen. This somewhat cumbersome process was not cost effective because there was no arbitrage market to tighten the “bid/ask” spreads. Over time, the most active intersections received their own quotes to assist with commercial and tourist transfer transactions. The GBP/JPY pair has developed as one of these favorite cross pairs.
If you look at the current BIS forex trading data by volume, the top seven pairs consist of the seven major currencies, each paired with the US dollar side. Surprisingly, the following 21 pairs are for Forex pairs. The move off the gold standard and the creation of a worldwide floating foreign exchange market also benefited global trade. As globalization modernizes international trade, the status of cross-currency transactions has grown. These transfers no longer need to be burdened by double diffusion costs.
Spreads have certainly come down over the years, but they are nowhere near what you would find for EUR/USD. Trading desks with justified trading volume, risk and cost still greatly influence spread selections, but as cross pairs are now more popular, spreads have been tightened. Sometimes, a major commercial bank may specialize in cross currency pairs for countries where it has a physical footprint, thus creating a cheaper way of dealing with a particular pair.
What are the typical spreads for forex pairs, and how do they compare with the major pairs? If we start with the “GBP/JPY” example from above, you can repeat the old process by getting the “Bid/Ask” prices for both “GBP/USD” and “USD/JPY”. You start with a fixed number of US dollars. The calculations are tedious, but you will reach a spread of approximately 4 pips. If you check a broker like eToro for the “GBP/JPY” pair, the spread is about half, or two pips, which is slightly higher than the “EUR/USD” standard of about 0.7 pips.
Spreads also vary depending on the time of day, which exchange center is quoting, and whether two pairing positions are open at the same time, but the conclusion is clear. Volume is an important factor in determining quoted spreads. Another popular example on the commodity currency front is the CAD/JPY pair. Spreads widen to approximately 6 pips versus 2 for “GBP/JPY”. The latter’s daily trading volume is actually a “6X” multiple, but the spreads have only tripled, as a result of speculation and arbitrage. For more simple pairs, you may experience spreads of up to 10 pips.
Where can one encounter cross-currency transactions? As a retail consumer traveling across borders, you may have converted one currency to another without going through US dollars. Credit Card Transactions also does the calculations for you instantly using the average currency value of the transfer. A cross Forex transaction is often part of international trade or debt transactions where multiple currencies play a role.
In the latter case, cross-currency swaps are the vehicle used, and parties will then return to the options market to hedge forex risks. Finally, arbitrage provides another opportunity when access to local currency markets can reveal imperfections in market prices. Using triangulation, a trader literally converts one of the currencies into US dollars and then buys the opposite pairing to make a profit. Global banks were active in the past in arbitrage strategies, but this practice is now rare because today’s market quickly corrects even the smallest discrepancies.
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The most popular cross currency pairs
As a Forex trader, you are familiar with the eight major currencies – the US dollar, the euro, the Japanese yen, the British pound, the Australian dollar, the Canadian dollar, the Swiss franc, and the New Zealand dollar. However, the definition of the major cross does not flow directly from this list. You may be able to find a list of forex pairs from your favorite forex trading site, but this classification is for cross pairs that feature dedicated market makers from either the Interbank sector or the brokerage community.
The major crosses tend to fall into a group of four pairs – EUR/JPY, GBP/JPY, EUR/GBP, and EUR/CHF. The first three follow volume demographics, but the recent pairing of the Swiss franc to the euro is key given its support by interbank market makers or brokers. From a pure volume perspective, the AUD/JPY and EUR/AUD exceed the EUR/CHF. Brexit has also pushed forward the popularity of the EUR/GBP pair.
Outside of these four major crosses, there are several minor crosses, which are different combinations of the seven major currencies, excluding the US dollar. Although trading volumes may be much smaller and spread out a little more widely, these rallies are becoming common in the forex trading arena. Trading opportunities abound if you follow a disciplined plan to identify and take advantage of a good trading setup. List of simple crosses is here.
How to trade cross currency pairs
Trading cross currency pairs can be an exciting new arena for the experienced trader looking to expand his horizon for opportunistic trading setups. In some cases, more risk, cost and volatility may be the order of the day, but the ability to predict pricing behavior may suit your trading style to your advantage. When USD pairs are in a wide range, cross pairs may be trending.
There are some things that a trader should consider. First, what is the base currency of your account? If you are trading the GBP/JPY currency pair and your account is denominated in EUR or USD, you may be at the mercy of your broker when they convert your trading profits and then send them to your account in a different currency.
Let’s take a look at the chart, provided by eToro, of the GBP/JPY pair:
During this period, the Fed announced potentially upward changes in interest rates, strengthening the US dollar and weakening relations with the British pound and the Japanese yen. By trading this pair cross, there is a relatively predictable up and down trend flow which provides a good swing opportunity for position traders.
Another popular cross pair is the CAD/JPY commodity pair. Once again, thanks to eToro:
In this case, the dominance of the US dollar is eliminated, and you see a positive upward trend, supported by rising oil prices. Japan must import almost all of its oil, and the result is that this contradiction between the two economic models works to the Forex trader’s advantage. Let the trend be your friend!
If you are an active Forex trader and want to expand your range of potential trading setups and opportunities, cross currency pairs may be a green area for you to explore. These pairs are not overly dominated by the dynamics of the US dollar and the US economy, but spreads tend to be wider, and periods of high liquidity may not correspond favorably to your time zone. However, due to the inherent pros and cons of cross currency pairs, they offer opportunities where fundamental relationships may be more predictable, even when trading costs are slightly higher.
Trade cross currency pairs with the best brokers
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