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How to Choose Which Currency Pairs to Trade?

Some currency pair are very volatile, while other currency pairs like to take it easy, exhibiting slow rallies up and slow moves to the downside. Some are better for trend trading, others are profitable if traded with mean reversion trading methods. No currency pair is immune to change however. The perfect example for this was the EUR/GBP from the second half of 2003 to the second half of 2007. The Pound and the Euro were moving together almost pip for pip. If the EUR/USD was to fall by 10 pips, the GBP/USD followed suit. This resulted in a very tight trading range in the EUR/GBP.

The chart above shows the 2003 to 2007 trading period on the EUR/GBP Weekly chart. The currency pair had a maximum peak to trough range of 7 to 8 percent during the entire four year period. The highest high was 0.7109 and the lowest low price ever got to was 0.6535. As can be seen from the picture, this currency pair was great for trading mean reversion systems until the 2007 / 2008 Financial Crisis destabilized the relationship. With a large financial sector compared to GDP, the Crisis had a much bigger impact on the UK than on Europe. This resulted in a lower Pound and as a result the EUR/GBP rallied over 900 pips in the first few months of 2008, a move 1.5 times larger than the entire 4 years before it.

Criteria for selecting currency pairs

The reason I mentioned the history of the EUR/GBP is to disarm critics that might say ‘’Just tell me which currency pairs to trend trade and which pairs to range trade. I don’t have time to go over all forex pairs on my own looking for the perfect financial instrument. ‘’ I could do that and I will offer some suggestions regarding this, but it is much more important for you to learn how to judge currency pairs yourself because like shown with the EUR/GBP example, the situation can change in an instant.

How to pick forex pairs for day trading

The two things that are most important in day trading are movement and transaction costs. It doesn’t matter if a currency pair moves up or down, it just matters that it does move. We’ll use two metrics to judge the best movement / costs ratio. For measuring the movement, we’ll use the Average True Range technical indicator. Like the name says, this indy shows the Average Range of the past X trading periods. A 20 period ATR applied to a daily chart shows the average daily range of the past 20 days. We’ll use the 100 ATR also applied to the Daily chart. Let’s apply this indicator to a currency pair that moves a lot in pips terms during the day, the GBP/JPY.

The chart above shows the ATR 100 on a Daily GBP/JPY chart. The current ATR is 1.50, or 150 pips. This means that during the last 100 days the Geppy moved an average of 150 pips every 24 hours, measured from the highest high to the lowest low of the day. Now let’s apply these same settings to a daily chart of the EUR/USD during the same time period.

The picture above is of the ATR 100 on a EUR/USD Daily chart. The current ATR for the Euro is only 0.0083, or 83 pips. This is a lot lower than the 150 recorded by the GBP/JPY.

The second step is to measure our transaction costs. For this, we can use popular forex websites dedicated to showing broker spreads. The two most popular options are http://www.myfxbook.com/forex-broker-spreads and http://www.fxintel.com/live/ . Myfxbook is more convenient because in addition to displaying the average daily spread during the last 24 hours, it also breaks down how the spread moved throughout the day in the different trading sessions. By examining these sites, we can see that the average cost to enter and exit a trade on the EUR/USD (this includes spread + commission for ECNs) was around 1 pip. The same cost on the GBP/JPY averaged around 2 to 3 pips. In addition, the lower liquidity on the Geppy is bound to cost you an extra 0.1s pips slippage on every entry and exit.

Now that we have measured both the movement and the cost, we have all the stats needed to judge which pair would be better suited for day trading. With an average daily range of 83 pips and a turnaround trading cost of 1 pip, the EUR/USD has a range to cost ratio of 83. For the GBP/JPY, the daily ATR was at 150 and the cost per trade average between 2 and 3 pips. This leads us to a trading range to cost ratio of 50 – 75. Since a higher value is better, we arrive at the decision that the Euro would be better suited for day trading. Of course, ultimately this is just a guide and the real test will come when you start to actually day trade your chosen currency pair. Some traders prefer trading the Euro while others live and die by the volatility displayed by the Geppy. Although the day trading filters we used above are useful to cut on time, in the end it will come down to which pair better suits your trading personality.

How to pick forex pairs for mean reversion strategies

Next, we’ll tackle how to pick currency pairs that you can use for mean reversion (range trading) strategies. The technical indicator we’ll for this is Bollinger Bands. What you want to look for are currency pairs that swing back and forth between the top and bottom band. The daily chart of the EUR/GBP below covers the same time period we wrote about above. Like we mentioned previously, the Euro and the Pound were moving together almost tick for tick resulting in a rangebound EUR/GBP.

Notice how prices kept bouncing between the Bands. Another simple technique is to just measure how far the currency pair has travelled from the left of the chart to the right. Here, the EUR/GBP was trading at 0.6850 on the left end of the chart (July 2005). At the right, the currency pair was quoted at 0.6834 (July 2006). In a year’s time, the pair only fell by 16 pips, a negligible amount for that long of a time period.

How to pick currency pairs suitable for trend trading

How do you pick suitable forex pairs for trading trends? For this we’ll use the most common trend following indicator, the moving average and basic price action. In one of my other entries I explored the 50 and 200 simple moving average crossover. To repeat, under this trading setup a long signal is generated when the 50 SMA goes above the 200 SMA. A short is initiated when the 50 SMA trades below the 200 simple moving average. The chart below shows the three MAs: the 50 SMA is shown in dark gold color, the 100 SMA is brown and the 200 SMA is black.

As you can see on the picture, the Euro didn’t trend very well during the past year. Europe’s single currency opened 2013 at 1.3265. On December 31st, one Euro was worth 1.3777 of a US Dollar. This is a move of less than 5 percent in a year, relatively small compared to the moves seen in the Yen related currency pairs. In addition, notice the large swings back and forth during the up move. At one point, the EUR/USD fell from 1.3710 to 1.2789, a down move of close to 1,000 pips. These large fluctuations are not good when tryinh to ride a trend. Not many traders would allow 1,000 pips stoplosses on their trades. Enter the GBP/JPY.

The Geppy trended exceptionally well in 2013. After opening the year at 142.22, the GBP/JPY rose to a multiyear high of 174.50 on December 31st. The currency pair closed 2013 not far from here at 174.32. That is a massive move of 3,210 pips in a year, a lot better than the measly 512 pips seen in the Euro. In addition, notice how price kept going up nicely with no major retracements in between. The MAs provided support to the move up, price rarely moved below the 50 simple moving average and when it did, it stopped at the 100 SMA. Look for these clues when choosing a currency pair suitable for trend trading. Adding an ATR value to judge the average daily range can also be helpful, volatility is a friend of trend following systems.

Investing | Forex | Trading


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