In the stock market, a trader has the opportunity to choose from more than 5,000 companies—hundreds of which will rally in the most vicious of bear markets and thousands of which will crash during the strongest of bull markets. In the currency market, however, finding trading opportunities is simplified because there is a narrower investment selection. Forex traders can use currency crosses to make a wide variety of trades that are unaffected by the day-to-day fluctuations of the greenback.
When dealing with the major currency pairs, most traders are presented with only two choices: buy the dollar or sell the dollar. Regardless of whether a trader decides to go long with the GBP/USD (British pound-U.S. dollar) or the EUR/USD (Euro-U.S. dollar), or go short with the USD/CHF (U.S. dollar-Swiss franc) or the USD/JPY (U.S. dollar-Japanese yen), the trader is bearish on the greenback. Therefore, the choice between these four trades is somewhat immaterial since all of them are linked to the U.S. dollar's movement. Granted, this is a gross oversimplification of the forex market. We'll be the first to acknowledge that not all currency movements will be tailored to this paradigm—the New Zealand dollar during the summer of 2008 was one good example. Given the country’s reliance on exports for economic growth and its geographical proximity to Australia, the New Zealand dollar’s exchange rate has a notable correlation to both commodity prices and the Australian dollar (which itself has a strong correlation with gold). As a result, while major currencies like the euro have held strong against the U.S. dollar, a drop in commodity prices has weighed heavily on the New Zealand dollar. On the other hand, when the markets are willing to take on risk and carry trades thrive, the New Zealand dollar tends to crush the U.S. dollar while other currencies, like the Japanese yen and Swiss franc, may suffer.
Trading simply on your own bias of the U.S. dollar versus other currencies will rarely yield uniform results. Some currencies appreciate substantially greater against the dollar, while others barely gain even a few points. This disparity in performance against the greenback creates many trading opportunities for market players who choose from the wide array of currency crosses. When simplified, currency crosses merely measure the relative strength of one individual currency against another, and are distinguished by the fact that they do not include the U.S. dollar in the pair. As such, they offer traders tremendous opportunities to go beyond the simple trading strategy of buying or selling the dollar.
For traders who likes taking on risk, Japanese yen crosses may be attractive because they can be just as volatile as the Dow Jones Industrial Average, but allow for easier short-selling during bearish times. Meanwhile, when the financial market sentiment remains broadly risk-seeking, trading crosses can focus on carry-trading strategies that look to profit from the interest-rate differentials between different currencies. Alternatively, some crosses can trend for months, such as the EUR/USD. Indeed, this pair has dropped almost nonstop since June 2008, and traders who have chosen to trade with the trend have profited significantly. Meanwhile, others can be highly range-bound for weeks or months at a time, such as the EUR/GBP since March 2003. In short, the possibilities with currency crosses are endless.
Consistent disparities in economic performance can often bring many trading opportunities in currency crosses. One example is the performance in the third quarter of 2008 in the EUR/CHF currency cross. Widespread fear for financial markets in the United States saw a slight to the markets of Europe during the first half of the year. By August, it had become increasingly clear that Europe was not immune to the pervasive bank weakness and credit crunch. However, the smaller and more nimble Switzerland did not suffer from the political and institutional disarray that pervaded the Eurozone’s 15 separate governments amidst the banking crisis. Furthermore, with much better unemployment numbers (2.4% in Switzerland vs. 7.5% in the Eurozone) and more robust retail sales (0.0% vs. -1.8%), Switzerland was clearly outperforming its much larger next door neighbor. As the realization of this fact began to permeate the market, the EUR/CHF cross (one of the least volatile crosses in the market at the time) declined by over 700 points in the third quarter alone.