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Forex Essentials Course: 21 lessons to get started in Forex

5. Forex Pairs − Characteristics and Qualities

Wed, Oct 22 2008, 10:46 GMT
by PFX Team

LearningMarkets.com

Classifying the forex as an investment type

If you are interested in higher yields and can tolerate high risk there are bonds and small cap stocks that fit that description neatly. If you are interested in technology companies or environmentally “green” companies there are convenient ways to find equities or private investments that fit those categories. Putting forex pairs into categories in a like manner is much more difficult.

Currencies reflect the performance and policies of entire economies, sovereign governments and industry. The blend of factors that can affect a currency change everyday.

Because of this unusual situation and the fact that there are relatively few currency pairs available to trade, two myths have arisen.

Myth #1 – Trading currency is easier because few pairs means it’s easier to find trades.

I hear this one at seminars/sales pitches all the time. It is not true. The financial markets have a remarkable equilibrium. If it is easy and/or safe, returns are low. If it is difficult and/or hard, returns are higher. Any experienced trader will tell you that having fewer choices presents some unique hardships. For example, it is more difficult to diversify, many of the available pairs are correlated and there isn’t much variation in risk levels.

Myth #2 – Currencies fall into discrete categories and can be used as replacements for other asset classes.

Traders are trapped by this myth when they begin evaluating a currency as though only one or two factors can affect its value. For example, some traders may assume that the only factor influencing the CAD is oil price, or that interest rates exclusively push the USD.

To be clear, there is a lot of valuable information that can be gathered by looking at the intermarket environment and certainly some factors do exhibit enormous influence over different currencies. But these groups or categories will overlap and are not exclusive. And they do not always behave in ways that related asset classes would.

Currency Characteristics and Categories

There are convenient ways to understand what might influence a forex pair and to understand its relationship to other currencies.

Any economist will tell you there are three things that affect exchange rates:

We usually ignore the third factor because it is such a small part of the forex. All the other news you see everyday is only important because it is the information that traders use to forecast changes in those primary forces and expected movements in exchange rates.

These factors provide context for identifying what will affect a currency. For example, if yields (returns from bonds and other investments) are extremely high in a particular economy compared to others, that affects capital flows and will be a major factor in the currency exchange rate. That also means that those currencies will be very sensitive to any changes in the credit market, interest rates or yields. It may even overshadow other historically dominant factors like exports.

For our purposes, we divide currencies into two groups and cross them with the USD as a common denominator. The first group, the Trade Currencies, are those historically most influenced by trade issues.

The second group, the Capital Flow Currencies, are those most affected by changes in capital flows (money in and out of an economy). Keep in mind that there is a lot of overlap and since yields can change over time, the emphasis you place on one factor over another may shift.

International trade currencies: These currencies are heavily influenced by changes in global demand for raw materials (commodities) and finished goods. A few of them (CAD, AUD, NZD) are often referred to as the “commodity currencies.” Currently the GBP, AUD and NZD also have very high target interest rates in their economies and are therefore also very sensitive to changes in the forces behind capital flows such as interest rates, the credit market and yields.

GBP/USD
AUD/USD
NZD/USD
USD/CAD
USD/JPY

Capital flow currencies: These currencies are heavily influenced by changes in demand for investments including equities, bonds and interest bearing investments. You will notice that there are some currencies that overlap. This is not accidental. It is impossible to rigidly define them.

EUR/USD
GBP/USD
USD/CHF
USD/JPY

How to use this model in your trading

Here is a great example of how this can be used in your trading. Over the 12 months preceding this article the median target interest rate amongst the majors was 4%. The outlier on the high side was the AUD with an interest rate over 6%. This means that the AUD was going to be extra sensitive to trade issues as well as anything that may affect capital flows. The small blue arrows show whether Australia’s trade numbers improved or declined. You should be able to see a very high correlation with the subsequent movement in the currency pair. However, the real price shocks were associated with disruptions in the credit market. As an interest rate leader, the AUD was very sensitive to these changes.

Knowing what may impact prices in a pair is vital to a forex trader. It’s like a racecar driver who needs to understand speed, force on tires and inertia.

Forex Essentials Course - 21 lessons:

1. What is the forex
2. Supply and Demand 
3. How Trading Works - Interbank and the Forex 
4. Choosing a Dealer
5. Forex Pairs - Characteristics and Qualities
6. Earning Interest in the Forex
7. Margin and Leverage
8. Short Term vs. Long Term Trading 
9. Forex Futures vs. Spot Forex Accounts 
10. Fundamental Analysis in the Forex 
11. The Calendar and Economic News 
12. Introduction to Charting and Technical Analysis 
13. Support and Resistance 
14. Fibonacci Analysis 
15. Price Patterns
16. Continuation Patterns
17. Reversal Patterns
18. Technical Indicators
19. Portfolio management – Diversification
20. Portfolio Management - Position Sizing and Stop Losses
21. Introduction for Forex Options

Published on  Thu, Nov 20 2008, 10:04 GMT