Choosing The Right Currency Pair

Discover a revolutionary new forex robot. The choice of the right currency pair in forex trading is very important. Many traders make the mistake of shaping opinion around only one currency, ignoring the other currency in the pair. Learn forex scalping.

US Dollar is the most important currency in the global economy. It is heavily traded against other currencies like Euro, British Pound, and Yen etc. Many trader trade currency pairs involving USD. They make the mistake of only studying US Dollar while ignoring the other currency in the pair.

In the forex market, this neglect of the foreign economic conditions can greatly hinder the profitability of the trade. It also increases the odds of a loss. You need to understand a little bit of fundamental analysis when you make your choice of the currency pair.

When you trade against a strong economy, the chances of failure are more. The weak currency in the pair could flop badly while the strong currency in the pair may appreciate more than what you calculated.

You must study the economies of both the currencies before you decide to trade a particular currency pair. The best trading strategy is to find the strong economy/weak economy pairing. This has the potential of giving maximum returns.

Let’s take an example, FED announced its intention of containing inflation in March 22, 2005 Federal Open Market Committee (FOMC) meeting. Most of the other currencies tanked against the dollar on the release of the announcement. Other positive economic data also reinforced the dollar.

When the initial reaction was over, GBP rebounded and recovered its strength, due to the impressive economic growth of British economy at that time. However, Yen kept on depreciating due to the week performance of the Japanese economy during that time. Dollar gained more than 300 pips in two weeks against the Yen during this time.

Therefore, USD strength had a much higher impact on the struggling Yen as compared to the consistently strong GBP.

When you choose a currency pair, study the economies of both the currencies in the pair. You also need to examine the behavior of various crosses. In nutshell, the best choice is always choose the strong economy/weak economy currencies.

Currency pairs are interrelated in the forex markets. As a forex trader, understand that the price action of each currency pair is not independent of other.

Different currency pairs move relative to one another. You need to understand that different currency pairs are correlated. Correlation can be positive or negative.

Knowledge of the strength of this relationship and its direction can help you in developing your trading strategies. Correlation numbers have the potential to become a great trading tool for you.

Correlations are numbers ranging between +1 and -1 that are calculated based on past pricing data between different currency pairs. These numbers can provide you with information that can maximize your trading returns, minimize risk and help avoid counter productive trading.

Lets make it clear with an example. Suppose USD/JPY and USD/CHF had a positive correlation of +0.83 last month. This number is close to +1 and means that both pairs are moving together most of the time in the same direction.

Now, if you are trading USDJPY and USDCHF at the same time, it will double up your position if you take long positions or short positions on both at the same time. If you lose a trade on USDJPY, the chances are that you will also lose the trade on USDCHF 83% of the times.

Let’s take another example. EUR/USD and USD/CHF both have a negative correlation of -0.9 in the last month. It means both the pairs were moving in opposite directions last month. If you take long position on one, it is not a good strategy to take short position on the other. It will only double up your position again and increase risk.

If you are investing in two currency pairs simultaneously, try choosing such pairs that have correlations near zero. Zero correlation means the two pairs are independent of each other in price action.

Don’t forget that currency markets are constantly changing. The correlations between pairs also keep on changing. It would be good to calculate the correlation numbers between pairs on a monthly basis.

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