Forex traders are always ahead in finding ways to profit from the financial markets. And do they want to access the market for unlisted currency pairs? They developed a strategy for trading synthetic pairs.
Briefly, a synthetic currency pair is the trader’s created pair. It involves trading two pairs with a buffer currency to serve as the base and quote currency of the two pairs. The buffer currency shall cancel one position, leaving the synthetic currency to create its exchange rate.
In this TRU Insight, we explore everything you need about synthetic currency pair trading. Read on and discover if this forex pairing is for you.
Quick Recap: What Are Currency Pairs?
Currency pairs are your asset to access and ultimately profit from the foreign exchange (forex) market.
What you do here is simultaneously buy and sell the currencies included in the pair. This follows the logic of exchange rate movement, suggesting that an increase in one currency could lead to a decrease in the other. Simply imagine the currencies in the pair playing on a seesaw.
All currency pairs consist of a base currency and a quote currency. When you open a long position, you buy a unit of the base currency using the exchange rate in the quote currency. On the flip side, opening a short position means you sell the base currency to buy the quote currency.
Assume you want to trade the EUR/USD market – you have the euro as the base currency and the US dollar as the quote currency.
- Opening a long position – buying a unit of EUR using the pair’s exchange rate in USD
- Opening a short position – selling the unit of EUR to buy USD in the pair’s exchange rate.
Essentially, you’re comparing the pair’s valuation by looking at the economic performances of the United States and the countries in the Eurozone.
Here are the three primary types of currency pairs you can use to trade in the forex market:
Major Pairs
| Symbol | Base-to-Quote |
|---|---|
| EUR/USD | Euro to US Dollar |
| USD/JPY | US Dollar to Japanese Yen |
| GBP/USD | British Pound to US Dollar |
| USD/CHF | US Dollar to Swiss Franc |
| AUD/USD | Australian Dollar to US Dollar |
| USD/CAD | US Dollar to Canadian Dollar |
| NZD/USD | New Zealand Dollar to US Dollar |
Major pairs include the assets that quote the USD from other currencies of major economies. In other words, this is the pairing of USD to major currencies.
Major pairs are considered the most active markets since 80% of daily forex transactions are quoted in the USD. And guessed it right – they’re the most profitable forex assets to trade.
Minor Pairs
Minor pairs, also known as currency crosses, pair major currencies without the US dollar. This group categorization provides insights into the economic performance of other major economies than the US.
Here are the currencies quoted against one another in this minor pair group:
| Currency | Country/Region |
| EUR | Eurozone countries |
| GBP | The United Kingdom |
| JPY | Japan |
| CHF | Switzerland |
| CAD | Canada |
| AUD | Australia |
| NZD | New Zealand |
Standing tall in the global economy, these currencies share a significant impact on the forex markets. This makes cross-pairs as profitable as the majors.
Exotic Pairs
This category includes the pairing between major currencies and the currencies of emerging economies.
The following characteristics define an emerging economy:
- The country has been experiencing profound economic growth.
- The country has a liquid debt and equity market.
- The country’s economy is accessible to foreign investors.
- The country has a developed and reliable monetary regulatory system.
Here are some of the actively traded exotic pairs in the forex market:
| Symbol | Base-to-Quote |
| EUR/TRY | Euro to Turkish lira |
| GBP/ZAR | British Pound to South African Rand |
| AUD/MXN | Australian Dollar to Mexican Peso |
| USD/THB | US Dollar to Thai Baht |
| JPY/NOK | Japanese Yen to Norwegian Krone |
What Are Synthetic Currency Pairs?
There are now 180 legally recognized currencies in the world. If paired with one another, there should be 32,400 currency pairs in the forex market.
But that’s simply theoretical – forex brokers only provide access to actively traded currency pairs so as not to exhaust their system.
This inaccessibility to other non-actively traded pairs introduced synthetic currency pair trading – a strategy for trading two separate currency pairs to speculate the non-existing currency pair.
Assume you want to trade the EUR/ZAR (euro to South African rand), but your broker doesn’t provide access to the pair.
To speculate the exchange rate movement of this synthetic pair, you open a position on EUR/USD and USD/ZAR.
Essentially, what you’re doing here is:
- EUR/USD position – buying a unit of the euro using the USD
- USD/ZAR position – buying a unit of USD using the ZAR
By using the same base and quote currency on the two pairs (contextually, the USD), you created a buffer to access the exchange rate movement of the EUR/ZAR.
The simplest way to put it is as if you canceled out the US dollars on both positions by simultaneously buying and selling it.
Should You Trade Synthetic Currency Pairs?
Retail traders (you) shouldn’t trade synthetic pairs as it doubles the trading fees (spread, commission, swap fee).
Additionally, doing so locks up unnecessary capital as your used margin. Free margin (the capital used in the used margin) is essential to the safety of your trading account as it provides a safety net for your open positions – preventing margin calls or stop-outs.
Instead of trading synthetic currency pairs, you should focus on the popular currency crosses to ensure liquidity and potential profits.
How Can You Trade Synthetic Currency Pairs?
Sure, some traders trade synthetic currency pairs for a particular reason – it could be to hedge, diversify, or magnify the potential profit of an open position.
A trader must employ the following strategies to take advantage of synthetic currency pairs for this approach to be effective and safe.
Position Sizing
Synthetic currency trading requires you to open two positions at once.
With this, inappropriate position sizing could risk premature exhaustion or trading margin or capital usage. Sufficient capital or free margin ensures your open position remains supported during an extremely volatile market.
For this, you must think that the two positions should be viewed as one position when considering your risk exposure.
Assume you have a 1% capital rule for your USD 10,000 account – this means that you should only risk USD 100 for each open position. If you trade a synthetic pair, you split that USD 100 capital rule into two.
| Synthetic Pair | Capital |
|---|---|
| EUR/ZAR | USD 100 |
| EUR/USD and USD/ZAR | USD 50 each |
Currency Correlation Trading
Again, traders may trade synthetic pairs to hedge the running losses or magnify the running profits of their open position.
To do this, they could take advantage of the currency correlation.
Currency correlation shows the interesting harmony within the forex market – revealing that two or more currency pairs could move in either a similar or inverse direction.
Assume your long USD/JPY position is currently incurring losses. On the other side of the forex market, the synthetic JPY/ZAR pair is moving in a perfectly inverse direction. Thus, you plan on executing a short JPY/ZAR position.
Spread Management Approach
The primary risk of trading synthetic pairs is their underlying spread. Due to a lack of market interest, these pairs are often illiquid – making the spreads significantly wider than usual.
A trader who wishes to participate in the synthetic pair market should pay close attention to the market spread to avoid costly trading. This also ensures your alignment with your overall investment goal objectives.
