Which Currency Pairs to Trade?

During the 1-day course by Ed Ponsi, he touched on the criteria to decide which currency pairs to trade. I thought I will just put things in perspective and provide some links as to where to look for the information that we need.

Spread

Spread is like the commission that we have to pay for our trades in forex. It is part of our business cost in trading. Different brokers offer different spreads for the various currency pairs. Let's take CMS Forex currency spreads as a guide (quite indicative for spread across different brokers). Spreads could range from as low as 2 pips for EUR/USD to 8 pips for GBP/JPY. As a rule of thumb, currency pairs with the smaller spreads is certainly more attractive. However, one should also look at the price movement range (the average true range or ATR is a good guide)  for his trading timeframe (if it could cover the spread easliy). Those trading daily timeframe charts can look at currency pairs with larger spreads because the spreads would be relatively small compared to the profit potential.

Correlation

Ed Ponsi suggested to not open positions in correlated currency pairs at the same time. For instance, EUR/USD and USD/CHF are known to have very strong negative correlation (ie, when EUR/USD moves up, there is almost 90% chance that USD/CHF will move down). So when one go long on EUR/USD and short USD/CHF at the same time, he is almost like having positions on a single currency pair! If the trade goes against him, it is almost certain that he will lose on both currency pairs.

Metaf.net provides a good tool for determine the correlation between the different currency pairs. The bigger the number in the table would mean the 2 currency pairs are highly correlated with each other. If there is a '-' sign in front of the number, it just means that the 2 currency pairs are negatively correlated, like the case for EUR/USD and USD/CHF.

From this data, I actually found 1 currency pair to be least correlated with the other major currency pairs (based on daily data). Want to know which one? Leave me a comment with your email :-P

Currency Strength

Ed Ponsi mentioned during the seminar that during this period, he will not trade with USD/JPY. During times of recession like this, USD and JPY are traditionally the strongest currencies. USD because traders are buying US treasury bonds as a safe haven. JPY because of traders no longer wish to be in carry trades. When 2 strong currencies are paired up together, it will be tough to determine who will win the tug-of-war. Ed Ponsi prefers to look at currency pairs that are made up of a strong currency and a weak currency so that there will be long periods of trends. Trends are forex traders' best friends! Ed Ponsi also mentioned his favourite currency pair to be GBP/JPY at this point in time.

ForexPeaceArmy offers a calculator that calculates the relative strengths of the major currencies based on their price movements. I find this is a good gauge to find out which currencies are stronger and which are weaker.

Rollover

Every currency has an interest rate tied to it (as dictated by the individual central banks). FX Street has a good table on worldwide interest rates.

The basics of rollover (aka swap) in forex trading can be best explained with an example:

AUD interest rate is at 4.25% and JPY interest rate is at 0.3% at the moment

Let's say we are long AUD/JPY. We will receive positive rollover as we are long the currency with the higher interest rate (ie, the AUD). The idea is we will receive money for the position that we are holding (for the duration of time that the position is opened). The amount that we will receive is broker-dependant however.

Do not underrestimate this rollover amount. We may be able to pay for the spread with that! Hence, alleviating the cost of opening and closing our trades!

Now we have a better idea of how to choose which currency pairs to trade 8-)