Trading Currency Pairs

04/24/2019 9:05 am EST

Focus: FOREX

Paul Cretien

Retired Professor of Finance,

Traders can utilize ETF pricing to initiate pairs trade in forex markets, writes Paul Cretien.

For pairs trading strategies it is helpful if one side of the spread—whether it is a stock,  futures contract, option or exchange traded fund (ETF) —  is relatively volatile while the other component of the spread is less volatile, providing a level surface on which the volatile member can land occasionally. Trading a pair takes advantage of price gap between two relatively correlated products – selling one and buying the other. The higher more volatile component will usually trigger the trade by moving sharply above or below the usual spread (or basis) between the two components.

Below we show charts on three currency related pairs—the Australian Dollar vs. U.S. Dollar Index, the Japanese yen vs. the euro and the Chinese yuan vs. the euro — using the exchange traded funds (ETF) representing each of those currencies.

Australian Dollar

Japanese Yen

Chinese Currency

Sophisticated forex traders can trade the actual currency crosspairs as every forex contract is a pairs trade — buying one currency against the other— but ETFs trade like equities and are available to more retail traders and ETFs may be safer when contemplating a less liquid crosspair.

The actual ETFs are: The Wisdom Tree Chinese Yuan Strategy ETF (CYB), The Invesco CurrencyShares Australian Dollar Trust (FXA), the Invesco CurrencyShares Euro Currency Trust (FXE), the Invesco CurrencyShares Japanese Yen Trust (FXY) and the US Dollar Index DX-Y.NYB   U.S. Dollar Index.

The three charts show percentage changes in price from April 18, 2018 and the most recent differences between the price changes for the volatile vs. stable members of each pair. This is the spread that we expect to be removed by the price trends moving back together.

If we were only investing in the spread between prices of the ETFs, the potential profit would not be large. For example: 14% of a moderately priced stock or share in an exchange traded fund is not an exciting number. However, the funds closely match the price changes of futures contracts related to the underlying assets. Thus, the expected closing of a 14% gap may be exploited by trading the associated futures contracts – accepting the price differences on the charts as virtually the same as those that would be calculated over the same time period on the futures.

The potentially large profits from pairs trading currency ETFs make it clear that we are using the currency ETF price changes as an instrument for making profit from another type of instrument, futures or cash forex, and not from the securities issued by the funds sponsored by Invesco or others. They provide the knowledge of price changes that can be used for profiting from a separate market – for example, the futures market.

As the market for E-mini and micro E-mini currency futures contracts expands, these will further increase the number of alternative investments that may be based on ETF price changes without investing in the ETFs.

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