Most forex traders use forex to put on directional trades. In other words, they anticipate a direction and trade to profit from being right on that direction. The critical success factors in directional trading is finding a optimal entry and of course, timing the exit. The rewards of directional trading are great and commensurate with the challenges. In addition to directional trading, forex traders can also play volatility and Over-The-Counter options provide a vehicle for volatility plays. But today, I want to share some thinking on a different kind of forex trading that is available to the spot trader- correlation trading or spread trading.
Spread trading in forex goes beyond directional trades or volatility plays. Its basis is the Fact that the currencies reflect major fundamental forces that permeate global markets. These forces involve interest rate differentials, commodity cycles, global growth, and equity sector performance. The result is a powerful synchronicity between currencies themselves, and between currencies and other markets. The spread trader looks for the conditions when a currency goes outside its expected range of pricing. The spread trader is not playing a direction, but rather is playing a reversion to the mean. The spread trade, when it presents itself is a great opportunity to have fundamental and technical factors converge to produce a profitable results.
Lets look at an example of the EUR/USD and the GBP/USD
In the chart below we see the alternating cycles of the narrowing and widening of these pairs against each other.
Source: Bloomberg
It visually appears extremely wide. How wide? The following spread summary shows that the spread price is all the way out of the statistical distribution. It is at the tail and in the 5.73 percentile. We can surmise its not likely to last. Ultimately, any analysis has to provide actionable knowledge. So lets come to a conclusion.
Conclusion and Recommendation: Trade a narrowing of the EURUSD against the GBPUSD.
Even the beginning trader can spot an opportunity. This spread will not last. It will narrow in a variety of ways. The trader doesn't.
