Synthetic Cross Currency Trading in Forex
  • Synthetic Cross Currency Trading in Forex

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    In today’s article, we shall examine the concept of cross currency trading. Cross currency trading is not very popular among retail traders in the forex market, but this is an important way to trade currencies which is usually neglected.

    What are currency crosses? Currency crosses are pairings of currencies that do not involve the US Dollar. They include currency pairs such as EURJPY, GBPJPY, EURAUD, EURCAD, AUDJPY, etc. They were created in response to the difficulties that existed in converting one currency to the other in the currency market. In years gone by, it was simply impossible to convert one currency to another. To perform such an exchange, the trader would have to first convert the source currency to US Dollars, and then convert the US Dollars to the target currency. This system of exchange was full of complexities and that is why a system of exchanging currencies directly was devised.

    What is Cross Currency Trading?
    In the forex market, the concept of trading currency crosses simply means trading one currency (currency A) against another (currency B) by simultaneously buying currency A against the US Dollar and selling currency B against the US Dollar. By doing so, the trader ensures that he is long on the base currency in the cross and short on the counter currency in the cross. The reverse trade can also be taken, with the trader selling the base currency in the cross against the US Dollar and buying the counter currency in the cross against the US Dollar.

    Why is Synthetic Currency Cross Trading Important?
    Currency cross trading is an avenue that gives traders more choice and more opportunities in the market. If traders were given the choice of trading only currencies that carried the USD in the pairing, it would not provide for a lot of choice. For instance, there are times when trading USD currency pairings in the market may be too risky for the trader. An example of such a trade is the Non-Farm Payrolls, which may give results that are impossible to interpret. At other times, the US Dollar may be affected by several fundamental factors in the market which could make its movement a very choppy one. Now supposing in such a case, the trader intended to trade currency strength in a pair containing the US Dollar, such choppiness may make it hard for the trader to get the desired results. In such instances, it may be safer to trade a cross currency.

    Cross currency trading is also important for traders whose brokers do not offer the currency crosses on their platform, or where trading of such pairs carries enormous costs because of the high spreads that have to be paid. In these instances, trading a synthetic pairing of the base currency + the USD and taking an opposing side in the counter currency + USD will create the desired trade effect.

    Synthetic currency crosses can also be used to filter out trading information from the market that can be useful in trading the major currencies. How does this work? There are some major currencies whose movements are correlated. For instance, the Euro is correlated with the movement of the British Pound (GBP). In other words, wherever the EURUSD goes, the GBPUSD will follow suit.

    Sometimes, it can be a source of confusion for the trader to decide on which of the major pairs to trade when there is a trading opportunity that is USD-negative. I have traded news items where the EURUSD’s response was muted while the GBPUSD took off like a rocket. The answer to this predicament is to look for any currency crosses where the two correlated currencies now competing for the trader’s attention are paired. For the Euro and British Pound, this is the EURGBP. Where is the EURGBP heading to when you have such a situation? If the EURGBP is heading north, then the Euro at that time is fundamentally stronger than the GBP and it will be best to trade the EURUSD. If the EURGBP is heading south, then the British Pound has more strength than the Euro and the GBPUSD should be traded. This is a situation where a currency cross is used to assess strength or weakness of two correlated but competing currencies for the purpose of deciding which of their respective pairings to trade.

    Examples of Synthetic Cross Currency Trades
    Let us take some examples of cross currency trades that traders can effect in the market. Let us assume that the trader wants to trade the EURZAR, based on some fundamental news that has hit the market concerning both the Eurozone and the South African economy. Perhaps there is a situation in the market that is Euro positive, and another situation in the market that is negative for the South African Rand.

    A discerning trader may want to profit from the situations affecting both currencies but may find the pairing of the Euro and ZAR missing from his platform. Very few forex platforms offer the EURZAR currency pairing, but it is likely that a platform will have the EURUSD and the USDZAR currency pairs. In this case, the trader can setup a synthetic cross pairing that will see him Buy EURUSD and Buy USDZAR so that the common currency to both pairs found on different sides of the trade will cancel themselves out.

    How do these two trades play themselves out?
    Long trade on EURZAR = BUY Euro, SELL South African Rand

    Buy EUR, Sell USD (one leg)
    Buy USD, Sell ZAR (second leg)

    The Sell and Buy positions on the USD will cancel themselves out, leaving the functional Long position on the Euro and the Short position on the ZAR to be the effective trade in the market.

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