Exotic currency pairs offer a riskier approach to profit in the forex market as they are less liquid and highly volatile. However, trading exotic pairs can be highly profitable if you understand how to deal with a volatile market.
What is an Exotic Currency?
Exotic currency is a rarely traded currency in the forex market, and playing a little role in the global financial system and not commonly used in international transactions. Usually, a currency of an emerging or a developing economy. Unlike major currencies like the Euro (EUR) and The Great British Pound (GBP), exotic currencies are more venerable to extreme price volatility due to the low trading volumes.
What are Exotic Currency Pairs?
Exotic currency pairs are the forex pairs that include one major currency against a currency of a developing or emerging market. For example, when a major currency like the US Dollar is paired with an exotic currency like the Turkish Lira, it is known as an exotic pair. Exotic pairs are not as liquid as majors or crosses, so they are characterized by higher volatility and price swings. USD/TRY and USD/MXN are among the most popular exotic currency pairs.
Currency pairs in the forex market are divided into three main categories:
- Major Pairs: The major pairs are the most traded major currencies against the US Dollar. These pairs enjoy high levels of liquidity due to the elevated trading volumes. Examples of major currency pairs are EUR/USD, USD/JPY, GBP/USD, USD/CAD.
- Cross Pairs (Minor): A cross currency pair is the currency pair that does not involve the US dollar. Despite enjoying sufficiently liquid markets, they are less liquid than the major pairs. The cross currency pairs with higher trading volumes are the ones that include a major currency. Some examples of cross currency pairs are; EUR/GBP, GBP/JPY, and EUR/CHF.
- Exotic Pairs: The pairs that include currencies of emerging markets. They are riskier pairs due to high volatility and lo liquidity.
Market Liquidity and Volatility Explained
Liquidity refers to how active the market is; how easily or quickly you can execute a trade. Typically, it is determined by the total active traders and total trading volumes.
High liquidity is one of the most common benefits of forex trading as it is accessible 24/5 with over $6 trillion dollars being traded on a daily basis.
The market’s liquidity has a big impact on how volatile prices are. The more liquid a market is, the lower volatile the price is. That’s why most forex traded pairs like the EURUSD normally do not experience high price fluctuations. On the other hand, exotic currency pairs fluctuate more often due to low liquidity.
Understanding Currency Pairs
Forex trading is primarily the process of exchanging one currency for another. That is why currencies in the forex market are traded in pairs. The currency pair is a quotation for one currency against the other; known as quote currency and base currency.
Currency pairs use the abbreviation of currency and country names. For example, the USD/JPY currency pair refers to the US Dollar against the Japanese Yen.
Understanding the pricing and quotation for currency pairs is very essential in forex trading. Currencies are defined as the base currency and secondary quote currency. The base currency is the first currency in a currency pair. Also known as the transaction currency. The quote currency is the currency being used to pay for the transaction, and it is also known as the counter currency or secondary currency.
Buying and selling currency pairs in the forex market always involves two currencies: the currency you’re paying with (the one you’re selling) and the currency you’re buying. This explains why currencies are traded in pairs.
If you’re selling the pair, then you’re selling the base currency, and the currency you’re buying is the quote currency. While in buying, you’re selling the quoted currency to buy the base currency.
When trading a forex pair, the prices are shown (the exchange rate) reflect how much it costs to buy/sell one unit of the base currency by selling/buying the quoted currency.
For example, in the EUR/USD pair the US Dollar is the quote currency, while the first currency (Euro) is referred to as the base currency. If the price of the pair is 1.1200, this means that then you need $1.12 to buy 1 Euro.
How to Trade Exotic Currency Pairs
Exotic currencies are more sensitive to changes in global risk appetite and interest rates. Like all currency pairs, trading exotic pairs should be backed by fundamental and technical analysis. Keep in mind that high price swings are always expected for exotic pairs.
So, is there an effective strategy to trade exotic currency pairs? There are multiple trading strategies to handle the price volatility of exotic pairs.
Range Trading: low trading volumes may cause prices to trade in a defined range for some time. It is when range trading is highly affective. Traders can profit from the peaks and throughs within the trading range to go long or short. Bollinger bands indicators is a very common indicator used for range trading. It is a volatility tracking indicator that consists of two bands or lines that represent the standard deviations above and below the 20-day moving average. The bands widen with increased volatility and narrow with low volatility.
Trend Trading: It is a simple and effective strategy for exotic currencies. Trend trading involves following the pair’s overall trend. Going long when prices are going up, and going short when they are falling. Identify the trend then decide your trade. Check more on Trend Analysis.
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