When trading FOREX, investors usually have major currency pairs
at their disposal, but if they wish to trade in some of the exotic
currency pairs, their options are somewhat limited. The problem that
traders face most often is that these exotic currencies are paired up
against either the US Dollar or the Euro; therefore, if someone wishes
to trade the Mexican Peso against the Japanese Yen, he would be out of
luck. Nevertheless, this trade is possible - it just requires a little
extra work on the trader's behalf.
In the above example of using
the Mexican Peso and the Japanese Yen, a trader could accomplish the
desired trade by tying the USD/JPY and the USD/MXN together. The idea in
doing this would be to have the zero USD exposure, giving the trader
the synthetic MXN/JPY pair. For instance if a trader wanted to go long
$5,000 worth of Mexican Pesos against the Japanese Yen, he would need to
go short 5,000 units of the USD/MXN (short USD/long MXN), giving them a
$5,000 short exposure to US Dollars and a long exposure of $5,000 worth
of Mexican Pesos. Then, to create the Japanese Yen aspect of the trade,
the trader must then go long $5,000 worth of USD/JPY pair (long
USD/short JPY). Combining these two pairs together, the trader has
created the MXN/JPY pair, because the USD positions cancel each other
out.
The next problem faced when creating synthetic currency pairs
is the ability to chart the created pair. Although the amateur investor
usually lacks access to affordable software programs that would chart
synthetic pairs intraday with technical analysis, Google Finance offers a
satisfactory alternative. Their site gives small retail traders the
ability to chart any synthetic pair over particular time periods (1
month, 3 month, 6 month, YTD, 1 year, 5 year, and a custom time frame).
Although the Google Finance option is extremely limited, it does give
traders an idea as to the performance of a particular pair over a
period.
While creating synthetic pairs may appear simple, the next
problem that a trader will come across is when a trade is in the format
of XYZ/USD, where XYZ is a particular currency. In this format, the
currency XYZ defines the number of units being purchased. For example,
if XYZ is the Euro, then a trader investing $100,000 would be buying
approximately 75,188 units of EUR (depending on the exchange rate, I am
using the 1.33 and rounding to the nearest whole number). Furthermore,
if XYZ is the Australian dollar, then a trader looking to invest
$100,000 would be purchasing 119,047 units of AUD currently trading at
.87. Currencies commonly formatted like this include the Euro (EUR), the
British pound (GBP), the Australian dollar (AUD), and the New Zealand
dollar (NZD).
When creating a pair with a currency like those
mentioned above, a trader must remember the difference in how he goes
about purchasing the units through his broker. For example, a trader may
wish to create the EUR/ZAR pair (ZAR is the South African Rand), but
the only way to accomplish such a trade through his broker would be to
pair EUR/USD and USD/ZAR. At first glance, a trader may think that it is
exactly like the above example with the MXN/JPY pair, but since the USD
is now purchased in terms of EUR (at today's price of 1.33), it would
take $1.33 USD to buy 1 EUR. As discussed, purchasing 75,188 units of
EUR/USD would create the $100,000 USD exposure. The number of units
depends on the exchange rate of the currency at the time of purchase; to
figure out how much of the EUR/USD to buy the trader would take the
total USD amount of $100,000 and divide by the current EUR/USD rate of
1.33. This would mean that the trader would have to buy approximately
75,188 units (note: this is not an exact number, it will most likely be a
decimal, there might be a small exposure to the USD) of the EUR/USD to
get $100,000 in USD exposure. Then the trader would go long 100,000
units of the USD/ZAR pair (similar to that of the above example using
USD/JPY), which would effectively cancel out the USD exposure, now
giving the trader a synthetic long EUR/ZAR trade.
One of the
problems with creating synthetic currency pairs is that they tie up
double the amount of margin as would be required if the exact pair was
offered through the broker. This also means that the trader must pay the
spread on both of the pairs that he will use in creating the synthetic
pair. This is not necessarily a problem, because if the pair was offered
directly through the broker interface, it would most likely have a
similar spread cost. The only disadvantage is the leverage factor, but
this is a moot fact, because any intelligent investor would not utilize
more than 10 times leverage in trading currencies, even though many of
these brokers offer up to 100 times on trades.
Synthetic currency
pairs can be difficult to create, but the ability to understand their
composition will open many more trading opportunities to traders.
