Hello traders! So you’ve read numerous Lessons from the Pros newsletters, been to an Online Trading Academy class or three, watched the Hour with the Pros archived videos, watched archived Extended Learning Track videos, and watched dozens of those XLT’s live. Your trading plan is robust, perhaps 6 or 8 pages long. Anytime you send one of your instructors an email, no longer are their responses correcting mistakes, pointing out things you missed, or providing basic Forex trading tips, but now they are writing you things like “Congrats, that is exactly how to trade, I took that trade as well!” You are well on your way to being a pro yourself and knowing how to trade Forex successfully.
In your trading plan you have chosen to trade up to two positions at a time. Because you have looked at hundreds if not thousands of different charts over in your trading, some of the often repeated patterns are jumping out at you and you know exactly what you are looking for. The basics of our core strategy – longer term charts for trend, medium term charts for supply and demand levels to join the trend, small time frames to fine tune your entry-are burned into your brain. So which currency pair will you choose to trade right now? Whichever is at the “best” level for your trading style. A few minutes or hours go by, and you want to add another trade to your portfolio. Do some pairs make more sense than others, and are there some pairs to perhaps avoid? Which should you choose?
The foreign currency market is a little different than most markets you have probably traded before – see some of my previous articles about the “curveballs” that exist in the marketplace. The main difference that we will discuss this week is the fact that each trade is a relationship trade – one currency’s strength vs. another currency’s strength. When looking at a chart of the EUR/USD, if the chart is trending upward then that means the EUR is getting stronger vs. the USD and when trending downward the EUR is getting weaker vs. the USD (or the USD is getting stronger vs. the EUR.)
Another quirk of the forex market to be aware of is the similarity of some currencies/economies. Generally speaking, the Australian dollar and the Canadian dollar (AUD and CAD respectively) are considered commodity plays – that is if gold or oil are trending up, the increase in prices should increase these two currencies. In an Economics 101 discussion, if gold goes up $500, I wouldn’t want to trade the AUD/CAD pair, as gold going up should make both of those currencies stronger-making the chart and my profit and loss moves very small. What I would prefer to do is trade a currency that would get stronger as gold moves up vs. a currency that gets weaker as gold goes up. Historically, the AUD/USD or the USD/CHF (US dollar vs. Swiss franc) would be good choices for a “gold trade” in the forex market.
Now, to the point of this entire article: suppose you have a trade where you are long the AUD/USD. A short time later you are looking at the USD/CAD currency pair. To your newly trained eye, the pair looks as if you could go long there as well. Should you take that trade? In our Economics 101 discussion, the answer is probably “no.” The reason is you are already long the AUD and short the USD. If you go long the USD/CAD, you are really going long the USD and short the CAD. Essentially the USD in these two pairs cancels each other out, and you are really long the AUD/CAD pair. (This thought process should be used for the majority of retail traders – yes I do understand the idea of hedging pairs vs. each other much like going long a strong stock and short a weak stock to hedge or pseudo arbitrage a sector. That is more of an Economics 440 than Econ 101 discussion!)
Could you then short the USD/CAD? Perhaps, provided you did understand that you were essentially “doubling up” on that commodity play. Much like buying a semiconductor stock, then buying another semiconductor stock, going long all the commodity currencies can actually add extra risk to a portfolio.
Here is a short list of pairs that usually trade together:
AUD/USD opposite direction of USD/CAD
EUR/USD opposite direction of USD/CHF
EUR/USD same direction of GBPUSD
There are many more relationships in this world of forex, but this is a nice start. Always know which side of the pair you are buying and which you are selling to help you decide if this pair makes sense.
So the main takeaway from this week’s article is this: when adding a position to your portfolio, be aware if you are adding to a commodity play-adding risk; if you are adding a pair that goes against the direction of a pair you already have – limiting reward; or balancing your account by diversifying – helping to limit risk by going from all commodity trades to an interest rate trade.
Until next time,