A very frequent question I get from traders starting out is, “Which pairs are the best ones to trade?”. Another subtle example of the conditioning people have accepted from equities trading. Modern Portfolio Theory along with just about every personal finance book and blog has pushed the idea of “diversification”. This means don’t bet on just one instrument, spread your risk across many and you should do better in the long run. Makes sense, but in the forex world it is not as simple as it is in equities trading.

It seems to me that many new traders in the forex market don’t understand the relationship of currencies that are paired with the U.S. Dollar, also known as the “Majors”. Pairs like EUR/USD, GBP/USD and USD/CHF are part of this group. The part most misunderstood is that basically all these pairs are just a slightly different expression of the strength or weakness of the Dollar. So if you buy EUR/USD and short USD/CHF you just doubled your position and your risk. If you buy EUR/USD and buy USD/CHF you just hedged yourself almost 1:1. Sure there are strategies that utilize such relationships, but as a beginner it is your primary objective to fully understand the instruments that you are attempting to speculate with. Without such a strong understanding, how are you ever supposed to get to the point where you can utilize advanced strategies like hedging?

What I suggest to the newer trader is this: Assuming you have a methodology that you have thoroughly researched and clear rules to follow, choose one major pair and get to know it. A good candidate is the EUR/USD and here are some reasons why:

Highly Liquid

Highly Correlated to S&P

Small spreads

Reasonable volatility

As a beginner the most important point you need to realize is if you are looking at a major, then you are trading the U.S. Dollar. There is no point jumping around in the beginning from pair to pair for whatever reason like you would in the equities market. The difference is in equities you have more than 5000 stocks to choose from, while in forex you have only a handful of majors and they are all related to the Dollar. The difference between major pairs really has to do with fundamental sensitivities and levels of volatility.

The next question I usually get is: “What about all the other non-Dollar cross pairs?”. Those are known as the “Crosses” or “Exotics”. I usually discourage beginners from engaging those pairs because of low liquidity and sometimes high volatility. Plus you need to know the various margin requirements and pip values before opening positions in these. They are not all the same.

As a newer trader, do yourself a favor and keep things as simple as possible in the beginning. Don’t worry about activity in other pairs or other areas of the market until you first understand how you are going to participate. This means you need to know what type of trader you are going to be and have a solid plan that streamlines your decision making process. Without the structure, you are going to have problems no matter what pair or instrument you choose.

—
Marc Principato, CMT

Risk Disclaimer

*No Relevant Positions