Choosing A Currency Pair To Trade Binary Options – Majors or Crosses?
Before you begin to trade binary options with currency pairs as the underlying financial instrument, it is important that you understand the main types of currency pairs and their trading implications.
Currencies – Majors and Crosses
Broadly speaking, currency pairs are split into two categories: majors and crosses. Majors comprise the most traded currency pairs in the world, with the Bank for International Settlements estimating that they account for as much as 85% of the global foreign exchange market. The 6 major currency pairs are the EURUSD, GBPUSD, USDCHF, AUDUSD, USDJPY, and USDCAD. Because of their popularity, the major currency pairs have highly liquid markets that trade 24hrs a day every business day. The high liquidity of the major currency pairs also means that spreads are extremely narrow. It is also worth noting that there is no official definition of a major currency pair; some people consider as few as 4 currency pairs as majors while some consider up to 8 or more.
Before we proceed any further, let’s understand how a currency pair is represented, using the GBPUSD pair as an example. In this case, the currency that appears first is the Pound, and this is known as the base currency while the US Dollar is known as the quote currency. Currently, the GBPUSD rate is about 1.23 meaning that for every 1 unit of the base currency (the Pound) you would receive 1.23 units of the quote currency (the US Dollar).
You probably noticed all 6 major currency pairs involve the US Dollar; this is because the US Dollar is the world’s reserve currency, a result of the Bretton Woods Agreement of 1944. All other currency pairs not in the majors category are known as minors or crosses. By definition, all currency pairs that do not involve the US Dollar as either the base or quote currency are crosses.
While by their very nature the market for crosses is less liquid compared to the majors, within the crosses category there are some pairs that are more popular and liquid than others. These are typically crosses involving the following currencies: EUR, JPY, GBP, and CHF. Within crosses there is also a sub-category known as exotics; these are usually non-Western currencies involving, for example, the Mexican peso, Turkish Lira, Thai Baht, Singapore Dollar, and Hong Kong Dollar. These exotic currency pairs have less liquid markets and thus higher spreads.
Effects of Economic Releases
As the value of a country’s currency is invariably tied up to the state of its economy, official (and sometimes unofficial) economic releases are one of the major drivers of currency movements. Perhaps the most watched event in currency trading is the decision by the Federal Reserve on the interest rate. This was seen recently in December 2016 when the Federal Reserves raised interest rates, leading to appreciation of the US Dollar. It is also important to note that much of the currency movements occur before the official economic release itself, as most people have a good idea, or at least think they have a good idea of what the official economic release is going to be. This is why we sometimes see no major movements after a major economic release; the currency movements have already been ‘priced in’. Of course, if the market has incorrectly predicted an official economic release, then major movements post-release will often follow.
Trading the Majors and Crosses
When it comes to binary options, it is more important to understand the basic characteristics of the major currency pairs first before delving into the crosses. This is for a couple reasons; firstly, many binary options brokers only the major currency pairs (you can always check what is offered by looking up the ‘Asset Index’ on the broker’s website) and secondly the major currency pairs are always easier to analyze due to the larger amount of data and third-party analysis available out there. Hence, as a beginner, it is wise to familiarize yourself by trading the major currency pairs first.
Here are some basic correlations between the 6 major currency pairs to get you started:
- EURUSD – Known as the Euro Dollar, this pair is often positively correlated with the GBPUSD pair and negatively correlated with the USDCHF pair. The reason for this is because the Euro, Pound, and Swiss Franc, being all European currencies, tend to be positively correlated.
- GBPUSD – Known as the Pound Dollar or the ‘Cable’, this pair is often negatively correlated with the USDCHF pair and positively correlated to the EURUSD pair. Again, this id due to the positive correlation between the Euro, Pound, and the Swiss Franc.
- USDCHF – Known as the Dollar Swissie or simply the ‘Swissie’, this pair is often negatively correlated to both the GBPUSD and EURUSD pair, again due to the reasons above. Also important to note: the Swiss franc is often considered a safe haven currency by traders in times of political unrest.
- AUDUSD – Known as the Aussie Dollar or simply the ‘Aussie’, this pair is often negatively correlated to the USDCAD, USDCHF, and USDJPY pairs simply because the US Dollar is the quote currency (instead of the base currency in the other 3 pairs). Another reason is that the Aussie and Canadian dollars are positively correlated due to both currencies being commodity block currencies, meaning that their economies, and hence their currencies, are highly commodity-based.
- USDJPY – Known as the Dollar Yen or the ‘Gopher’, this pair is positively correlated to the USDCHF and USDCAD pairs because in all 3 pairs the US Dollar is the base currency. This pair is also very sensitive to East-West political sentiments.
- USDCAD – Known as the ‘Dollar Loonie’, this pair is negatively correlated to the AUDUSD, GBPUSD, and EURUSD pair simply because the US Dollar is the quote currency in all those 3 pairs as opposed to the base currency in the USDCAD pair.
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References and Further Reading:
- Carry Trades and Currency Crashes (Markus K. Brunnermeier, Stefan Nagel, Lasse H. Pedersen)
- Stochastic skew in currency options (Peter Carra, b, Liuren Wu)
- Forex prediction with neural network: USD/EUR currency pair / (Y. Vyklyuk, D. Vukovic, A. Jovanovic)
- Does a currency union affect trade? The time-series evidence (Reuven Glicka, , Andrew K. Rose)
- Stochastic risk premiums, stochastic skewness in currency options, and stochastic discount factors in international economies (Gurdip Bakshia, Peter Carrb, c, Liuren Wu)