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 volalilty 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 EURUSD and the GBPUSD
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 have to predict how. The
spread trade lets the market take care of that. There are several ways to
tactically implement this:
1- Buy the GBPUSD and Sell the EURUSD as two separate positions.
2- Sell the EURGBP pair directly
3. Buy a Put on the EURGBP Pair- 3 month
4. Buy a Put on the EURUSD and a Call on the GBPUSD
All of these are in play and can allow the forex trader maximum flexibility
in adjusting strategies and tactics to their goals and risk tolerances.
There are many spread opportunities in today's market that traders should
explore. More will be pointed out in the future. The major point is that spread
analysis and trading can become a useful tool for the spot forex trader
Abe Cofnas is the president for Learn4x.com and founder of
Currencygames.com. He has provided a worldwide audience with analysis and
insight on what moves the forex market. He is noted forex trainer and speaker
and provides a a unique approach of integrating fundamental and technical
analysis. He was selected as the first forex trader columnist for Futures
Magazine, writing a monthly column covering forex for the last 7 years, and has
also provided unique content for their Web site. He is the author of The Forex
Trading Course- Published by John Wiley which provides a getting started
workbook on forex trading. Mr. Cofnas holds a Master's degree in political
science, and a second Master's degree in public policy analysis from the
University of California at Berkeley. He can be reached at: learn4x@earthlink.net
