A couple of currencies in which one currency is traded against another.

What is a Cross Currency?

A cross-currency refers to a currency pair or transaction that does not involve the U.S. dollar. A cross-currency transaction, for example, doesn't use the U.S. dollar as a contract settlement currency. A cross-currency pair consists of currencies traded in forex that do not include the U.S. dollar. Common cross currency pairs involve the euro and the Japanese yen.

Understanding Cross Currency

At the end of the Second World War, most currencies were pegged and quoted against the U.S. dollar. This was because the U.S. economy, in general, was the strongest post-war, and its currency was fixed to gold. This set precedents when converting two coins that weren't U.S. dollars.

Historically, an individual who wished to exchange a sum of money into a different currency would be required to convert that money into U.S. dollars and then convert it into the desired cash. Cross-currency transactions could be done under this system, but they sometimes still went through a U.S. dollar calculation to ensure a fair settlement. Although the U.S. dollar still acts as the world reserve currency, the rise of the forex market has made cross-currency transactions and cross currency pairs common. The GBP/JPY cross, for example, was invented to help individuals in England and Japan. They wanted to convert their money directly without having first to convert it into U.S. dollars.

More opportunities with cross pairs

Trading cross currency pairs can produce more opportunities for traders when added to their range of trading instruments.

If there are no setups on any significant pairs, you can look for trading opportunities on the cross pairs. This may be when the major teams are quiet or inactive during specific trading sessions, but the cross pairs may be very active. For example, during the Asian session, the EUR/USD may be pretty inactive, but the AUD/JPY may be very busy.

Nature of cross currencies

The U.S. dollar was the only world reserve currency for a long time, and to exchange from one currency into another, you had to first convert to U.S. dollars.

Cross currencies allowed direct exchange between two currencies without involving the U.S. dollar. However, because the U.S. dollar is still the most widely held reserve currency, the major pairs are traded much more often and are more liquid than the cross pairs.

The major pairs are traded more often and are therefore much more liquid. The major crosses are also very liquid but can produce more volatile movement. The exotic pairs are traded less, so they are even less liquid, creating more volatile movement.

The major crosses such as the EUR/GBP and the GBP/JPY are also very liquid due to the size of the economies behind these currencies, but less so than significant pairs. Exotic pairs are traded even less so and are even less liquid.

With less liquidity, the price can trend very well. If a financial institution or a bank trades a cross pair, fewer traders can potentially trade against them. So when significant moves do occur, they can be in the form of a long trend and may move quite rapidly.

Considerations when trading cross pairs

The point to bear in mind is that illiquidity can work as a double-edged sword. Just as a price can move quickly in one direction, it can reverse and retrace back just as quickly. Take a look at the chart to the right. You can see that the movement on the EUR/JPY currency pair experienced a rapid, volatile movement that saw a price decline, enter into a tight range before violently breaking back up.

Caution entering into a trend

Suppose you are trying to enter into a trend. In that case, you need to bear in mind that there could be some very volatile price movement within a range before a trend emerges – there could be many small losses before making money in an eventual direction.

Also, due to the illiquidity of the cross pairs, the spread from a broker can be higher, meaning that the trade cost is higher. These high transaction costs and the additional risks associated with volatility mean that exotic trading crosses should be carried out with caution.

Considerations: Price can move quickly in one direction and can reverse and retrace back just as quickly. Be careful when volatility is rushing in both directions.

Using economic reports to trade cross currency pairs

Financial data can provide an edge when trading cross pairs because cross pairs can produce strong trends. Determining strong demand for one currency and weak demand for the other can enhance the probability of a movement.

If a country produces economic reports indicating that the economy is robust, then the demand for that currency can rise.

Economic data can provide an edge when trading cross pairs because cross pairs can produce strong trends. For example, if a country has financial reports indicating that the economy is robust, then the demand for that currency can be expected to rise.

On the contrary, if a country produces weak economic figures, the currency is not expected to have such high demand.

If traders understand these principles, they will look to make money from speculation when these reports come out. Traders can therefore determine those countries with strong economies and trade these against the countries with weak economies.