When trading Forex, there is a multitude of currency pairs to trade from.
With that many currency pairs, how do you decide which currency pairs to trade?
One way is to find the most volatile currency pairs.
That is because traders think that the more volatile the currency pair, the more potential there is for profits.
However, that’s not necessarily true.
In fact, this is a huge misconception among new traders.
Because some of the most volatile currency pairs are designed to make it nearly impossible for the trader to profit.
So which currency pairs should you trade and which are the ones that you should avoid like the plague?
In this post, I’m going to show you exactly what to look out for in a currency pair, how to gauge their true volatility, and how to decide which currency pairs to trade.
Defining Volatility
The way the volatility of a currency pair is defined is by how big of a movement it makes.
Now, this can be subjective because if you’re trading intraday, then certain currency pairs might be more volatile depending on the trading session.
And also, certain currency pairs might be more volatile when there’s news.
So to objectively derive the volatility of a currency pair, I like to take the daily range of a currency pair.
For this, we use the Average True Range (ATR) indicator.
The ATR calculates the market’s movement over a set period as defined by the trader.
By default, it is set to a period of 14.
What that means is that it takes the last 14 bars and calculates the average range of the currency pair.
These 14 bars can be any timeframe the trader chooses.
If you use an ATR (14) setting on a 1-hour chart, then it calculates the average range the currency pair moves over the past 14 hours.
If you use an ATR (30) setting on a 1-min chart, then it calculates the average range the currency pair moves over the past 30 minutes.
So what settings should we use to get an “objective” reading of the currency pair’s volatility?
Many traders like to use the default setting of ATR (14).
However, I don’t use that setting because it doesn’t reflect the average range of the currency pair objectively.
For example, let’s say we use the ATR (14) on the daily chart of GBP/USD.
If in the past 14 days, there was the FOMC Meeting Minutes released and some news on Brexit that caught the market by surprise, then using an ATR (14) would result in a higher average range than normal.
So instead, what I like to do is normalize the volatility of the currency pair over a period of one year.
This will give a more objective gauge of a currency pair’s volatility as compared to just the past 14 days.
So what lookback period should we use as the setting to measure the past one year’s average daily range?
For this, we want to know how many trading days there are in a year.
According to Wikipedia, it states that there are roughly 253 trading days in a year in the US stock market.
Although the Forex market is generally opened more days in a year because certain pairs aren’t affected by the US holidays, we will use the setting of ATR 250 to have a rough gauge of one year’s worth of trading activity.
This will at least give a more accurate picture of the currency pair’s volatility in the last one year of trading.
Using the ATR (250) indicator from the TradingView platform, I’ve constructed a table of 40 currency pairs below (as of Jan 2020):
If you noticed, I’ve also added two additional columns to the right:
- Spread
- Spread-to-ATR Ratio
Spread
The “Spread” is basically the typical spread that the currency pair has.
For the purpose of this comparison, I wanted to keep it simple to identify which currency pairs makes sense to trade despite their volatility.
So I have used the typical spreads from Oanda because there are no commissions charged.
This makes the calculation much simpler for the purpose of understanding the spread’s effect compared to the volatility of the currency pair.
In actuality, you might want to use a broker that charge a commission but gives you thinner spreads.
But for this example, it makes it easier to illustrate what you should look out for when thinking of trading pairs with high volatility.
Spread-to-ATR Ratio
The “Spread-to-ATR Ratio” is a metric I’ve come up with to measure how big the spread is compared to the average daily movement in percentage terms.
The bigger the percentage, the lesser your edge trading this pair, with all else being equal.
Another way to put it is that the bigger the percentage, the bigger the “house edge”.
Which means the broker’s edge over you.
I call this a negative edge.
Ever gone to the casino before to play Roulette?
If you have, you will notice that there is a green zero number on the wheel.
That is the negative edge for gamblers.
Regardless of what gamblers bet on, they will lose in the long run because of this negative edge.
For example, the casino pays out 1:1 on bets on either red or black.
That means if you bet $1 on either red or black, your payout will be $1.
Now, if there were only 36 numbers on the roulette wheel, then betting on either red or black would be a 50% chance to win (18 red numbers and 18 black numbers).
With a 50% chance to win $1 and a 50% chance to lose $1, you should breakeven in the long run over a series of thousands of bets.
But because there is the “zero” on the wheel, it’s no longer a 50% chance to win red or black.
Instead, your chance to win either red or black is reduced to 18 / 37 = 48.64%
And that makes your chance to lose become 51.36%.
So think about it:
If you have a 48.64% chance to win $1 and a 51.36% chance to lose $1, in the long run, you WILL lose money.
And if you play the American roulette, the house edge is further increased because they have two zeros on the wheel.
That’s why the casino always wins when you play against them.
All the games are designed to give them a positive edge and give you a negative edge.
Understanding Negative Edge
Like any other business, trading is also a business.
For example, in traditional business, before you even make your first dollar, you already have upfront business costs.
Your costs may include things like:
- Rental
- Inventory
- Marketing & Advertising
- Website hosting & design
- Employees
All these are costs you have before you even start earning money.
I have a friend that started a restaurant business years ago.
Even before he has opened his restaurant, he had to pay for rent, renovation, food, hire employees, etc.
And that set him back close to 6-figures.
So even before he opened his restaurant to start making money, he is already down close to $100K.
Eventually, he ended up closing because he couldn’t make enough to cover the cost of running his restaurant.
When trading Forex, it’s very similar.
The moment you enter into a trade, the spread and commissions is already a sunk cost.
And the bigger the spread and commission, the more it will take for you to break even and profit.
Spreads and commissions are the broker’s positive edge against you.
Hence, your negative edge.
The idea is to keep this negative edge as small as possible.
Analyzing a Currency Pair’s Volatility
From the table of currency pairs I’ve created (shown earlier), you can see clearly that the most volatile currency pair is EUR/ZAR.
Now, in case you’re not sure what currency ZAR is, it is the South African Rand.
It has a daily average move of over 2000 pips!
That is quite insane because it moves 20 times more than the most volatile major currency pair, GBP/USD.
So, the question comes down to:
Should you trade the EUR/ZAR?
That’s where the Spread-to-ATR Ratio comes in to give us further insight as to whether this might be a good pair to trade or not.
So while EUR/ZAR moves over 2000 pips in a day, its typical spread in a day is roughly 96.4 pips.
That means the moment you enter your trade, you are already down 96.4 pips.
And to give you an idea of how big this spread is, that’s where the Spread-to-ATR Ratio comes in.
So if you take a look at the Spread-to-ATR Ratio, it shows 4.63%.
What that means is that the spread is roughly making up 4.63% of the daily move.
This is a huge disadvantage because it is a big negative edge to overcome.
What this means is that if you trade EUR/ZAR, it has to move at least 4.63% of its average daily move in order for you to break even.
But what if you traded EUR/ZAR intraday?
Let’s say you trade the 15-mins chart intraday.
A trade setup comes and you define your Stop Loss at 300 pips away.
With a spread of 96 pips, you would be one-third into your Stop Loss the moment you entered into your trade!
And let’s say you just want to take 1R as your Take Profit (300 pips).
With a 96-pips spread, you would require EUR/ZAR to move 396 pips in your favor just to take 1R, and a move of just 204 pips against you to get stopped out at -1R.
That is a huge negative edge.
Now compare this to EUR/USD.
EUR/USD’s average daily move is much smaller at only 65 pips.
However, the spread of 1.2 is only 1.85% of the daily average move.
That means EUR/USD only needs to move roughly 1.85% of the daily average move to breakeven.
Right now, I’m using a broker where the spread is only 0.1 pips on average.
And with commissions added, it roughly equates to 0.8 pips in total.
So that will be a smaller negative edge compare to trading the EUR/ZAR.
Conversely, the lower the volatility does not necessarily equate to lower spreads as well.
If you look at EUR/DKK, you will notice that it only has a daily average move of 20 pips.
But the spread is a whopping 12.9 pips!
That is 64.5% of the average daily range!
This is the daily chart of EUR/DKK:
The two white lines on the chart indicate the bid/offer spread.
Do you see how big the spread is compared to the movement it makes?
To put things into perspective, this is the bid/offer spread on the EURUSD chart:
The spread is so thin that you can hardly see it.
This is the kind of spread we want to look for when finding currency pairs to trade.
Not the kind of spread that EUR/DKK has.
Imagine trying to trade EUR/DKK intraday:
The chart above shows the 1-hour chart of the EUR/DKK.
The spread is even bigger than the typical range of the 1-hour candlesticks!
Even if you’re right in the direction of your trade, you’d need it to move enormously in your favor to be profitable.
So don’t even bother thinking of trading this currency pair.
You’d have much better odds gambling in the casino.
So how do we decide which currency pairs to trade?
Choosing the Best Currency Pairs to Trade
Some traders believe to stick with just one currency pair to trade and master it.
Some traders believe it’s better to have many currency pairs to choose from so they can choose the best setups when they come.
Some traders believe it’s best to choose the currency pairs that move the most in the day.
I use a different approach.
I choose the currency pairs that give me the most edge in my trading, even before I trade it.
So I break down my currency pair selection into two categories:
- Intraday Trading
- Swing Trading
For intraday trading, it means I will close my position before the rollover timing.
The rollover timing is where the broker will either pay you a positive swap or deduct from you a negative swap.
So for intraday trading, I only really trade GBP/USD and GBP/JPY because it has a nice daily range of more than 100 pips typically.
This allows for the chart patterns to show more distinctly for the trading strategies that I’m trading.
And the Spread-to-ATR Ratio is decent at around 2%.
This is actually lesser when I trade with my current broker where the spread and commissions equate to around 1 pip.
With that said, I do most of my trading doing swing trading where I will hold my positions overnight.
And for swing trading, I currently monitor 11 pairs:
- EUR/SGD
- EUR/USD
- EUR/CAD
- EUR/AUD
- USD/CHF
- USD/JPY
- SGD/JPY
- CAD/CHF
- CAD/JPY
- NZD/CHF
- AUD/CHF
There are two main reasons why I chose these pairs:
- They have a decent Spread-to-ATR Ratio with my broker.
- They pay a positive swap in the right direction.
Have a good Spread-to-ATR Ratio is important to reduce the negative edge.
And having a positive swap allows you to turn your negative edge, into a positive edge.
How to Turn A Negative Edge Into a Positive Edge
Trading by itself is already a very challenging endeavor.
So as much as possible, we want to get every edge we can get to increase the odds in our favor.
Now, we already know that a negative edge is the spread and commission of the currency pair.
And the bigger the Spread-to-ATR Ratio, the bigger the edge the brokers have over us.
So how do you turn this negative edge into a positive one?
There are two “positive edge drivers” to do that:
- Positive Expectancy
- Positive Swap
Positive Expectancy
Positive Expectancy is where you have a system that over a sizeable series of trade, you come up profitable.
It comes with tinkering 3 things:
- Win-Loss Percentage
- Amount Won Per Win
- Amount Loss Per Loss
Here’s the formula for calculating your trading system’s expectancy:
(Percentage of win x Average amount won per trade) – (Percentage of loss x Average amount loss per trade)
Creating a positive expectancy is a long-term pursuit for all traders.
Unfortunately, it’s also the thing that many traders struggle to achieve.
So while this alone can help you turn your negative edge into a positive one, it’s not an easy task to come up with for many traders.
And that’s where the next positive edge driver comes in to help.
Positive Swap
With positive expectancy, you can’t really control your outcome.
You can’t say you want a positive expectancy from this trading system and it will magically happen.
It requires lots of data to test the system and a sizeable trade sample size.
But with positive swaps, you can control it.
All you have to do is find the currency pairs that are paying a positive swap, and then wait for a setup in the direction of the positive swap.
For example, in this table below, it shows the swap rates for the different brokers for USD/CHF and USD/JPY:
These are based on 1 mini lot (10,000 units), and you can see that most brokers pay a positive swap for taking a Long position on both pairs.
So to get a positive swap, all you have to do is enter into a Long trade based on your trading strategy and hold it overnight.
And the best way to have a position that requires you to hold overnight is to trade the bigger timeframes like the 4-hour and daily chart.
Choosing the Right Currency Pair to Trade
You may have come here hoping to find which are the most volatile currency pairs to trade.
But throughout this post, you should have realized that finding the most volatile pair isn’t the best way to choose a currency pair to trade.
There’s no point trading EUR/ZAR where it moves 2000+ pips when the spread is 96+ pips.
You would have to overcome the enormous 4+% negative edge against you.
Instead, you want to find the currency pairs that are not only liquid, but also has the lowest negative edge against you.
And to turn the negative edge into a positive edge, you want to also go for currency pairs that give you a positive swap.
When you do that, you will be able to increase the odds in your favor.
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