What are forex cross currency pairs?
This might appear an odd question to ask a forex trader ‚Ä¶.yet, in a recent survey we conducted amongst traders¬†69% of them,¬†yep…69%¬†couldn’t tell us why a cross currency pair was different from a major pair! And many of these been trading for some¬†years.
Digging a bit it became apparent that the basic issue¬†was that a lot of traders don‚Äôt really understand the concept of pairs in the first place.¬†The problem¬†issue is that relatively few realise that when the take a trade there are ¬†infact TWO transactions were taking place.
How Forex Pairs Work
The best way to look at is is to use an example. Let us say that you are going long on GBP/USD. …What is actually happening is that you are buying GBP and selling USD.¬†It is actually very logical but few realise that this is happening.
The problem is, ¬†not all¬†currency¬†pairs are the same.
Why is it important to understand this you may ask? After all you make a profit on if a pair goes up or down, the way it is constituted is surely irrelevant? ¬†This is not true as the way the pairs are constituted has a big bearing on how they move.
The reason for this is is that not all pairs are the same, cross pairs are traded differently.
This¬†all goes back to traditional currency conventions.
In order to understand why forex cross currency pairs are different, you first have to know the quoting conventions for currency pairs in the spot forex market.
Each currency pair consists of a ‚Äėbase‚Äô currency (the currency on the left) and a ‚Äėquote‚Äô currency (on the right).
Traditionally, the base currency was always the larger of the two and despite the fact that relative currency values have changed, ¬†the conventions have pretty much remained the same, except for the addition of the Euro in 2000.
The conventional order of currencies starts with the Euro (EUR). The EUR is always the base currency in any pair it is a part of ie it is always on the left hand side.
Next comes the British Pound (GBP). The GBP is always the base currency except for when paired with the EUR.
The full conventional order of priorities for the base currency (with respect to major and minor currencies) is:
- Euro (EUR)
- British pound (GBP)
- Australian dollar (AUD)
- New Zealand dollar (NZD)
- US dollar (USD)
- Canadian dollar (CAD)
- Swiss franc (CHF)
- Japanese yen (JPY)
The Major Pairs!!
From this list a series of pairs, known as ‚ÄúMajors‚ÄĚ are created and ¬†traded.
Any other pair is a cross pair (So the majority of traded pairs are forex cross currency pairs of one sort or another)
So why just these as Majors?¬†Again here tradition again rears its head.
Somebody has to make the market and pretty much 80% of Forex volume ends with just few¬†major banks,¬†Deutsche Bank , UBS, Barclays Capital, and Citigroup being the principle ones.
Forex Cross Currency Pairs
Now these major banks only trade the majors. If you wanted to trade a cross pair the trade would be legged. This meant that two major pairs would be traded to create the cross.
How does that work?
For example let’s say you wanted to trade EUR/JPY cross. A Bank would Buy EUR/USD and Buy USD/JPY.
Now remember we talker of two transactions per trade, well with a cross there are effectively four.
So, in the example of the EUR/JPY
You are buying EUR, selling USD, (in the first part of the leg) then buying USD and selling JPY (In the second part of the leg). The two USD transactions cancel themselves out leaving you buying EUR and selling JPY, thus long on EUR/JPY
This animation in the video at the top of the page should¬†make this clearer.
First you have your the two pairs, Euro Dollar ¬†and Dollar Yen. To go long on them both you are buying Euro and selling dollar and buying dollar and selling yen. The dollar trades cancel each other out. leaving you with buying euro and selling yen. Thus you are long on EUR/JPY.
How does this impact on your trading:
Basically, if you were trading EUR/JPY ¬†you should be spending as much time analysing EUR/USD and USD/JPY charts as you do looking at the EUR/JPY chart. It is particularly important when you are scalping.
In the next training, we will go through how to utilise this information to better trade the most important cross pairs.