Globally, there are 180 recognised currencies, 130 of which trade independently (unpegged). Most forex traders will never trade more than a handful of these and with good reason: Very illiquid or unusual currencies simply do not have the sufficient volume to make profitable trades once your platform spreads are taken into account.
Among the few dozen currencies that are popular with retail traders, there are great differences. The market is still very concentrated: an overwhelming majority of trades involve the US Dollar; and almost all of them involve one of the other major currencies: the British Pound (GBP), Euro (EUR), Japanese Yen (JPY) or Australian Dollar (AUD).
Even amongst these major currencies, different pairs trade in a different fashion, and are influenced by varying economic factors. A particularly important phenomenon is the ‘commodity linked’ (sometimes ‘commodity backed’) currency – of which the AUD is one of the most well-known examples.
In this article we will examine in turn a few of the main groups of currencies, and how their different characteristics should influence your trading.
The FX market is a highly concentrated one. The majority of dealing goes on in just a few major currency pairs, and over 80% of all traded volume includes the USD on one side. Most FX traders end up primarily dealing in their home currency, the USD, and perhaps one or two other pairs.
In terms of overall volume, the largest currency pair by far is EUR/USD, followed by USD/JPY, GBP/USD and in fourth place AUD/USD. You have to go down to eighth place (EUR/JPY) to find the first dollar-free pair. This reflects the USD’s status as the global reserve currency.
The list of major pairs hasn’t really changed for decades, asides from the introduction of the Euro in 1999. Before the dollar become the first global reserve currency, major reserve currencies such as the British Pound operated on the gold standard, meaning that there was always an underlying asset setting a fixed value to all transactions. Overall global FX volumes were also much lower prior to the 1980s, and retail forex trading did not really exist on an appreciable scale until the end of the twentieth century.
Major currency pairs are normally less volatile, since they include the currencies of the largest and most stable economies. A related concept is the idea of a ‘safe haven currency’ – either the USD or the currency of another advanced, diversified economy. These should still be approached with caution; just because a currency pair is major does not mean it will be a tranquil market, and major pairs like the GBP/USD have seen periods of great volatility in recent years.
Commodity linked currencies (commodity currency)
This category of currency pair is so named because their value tends to closely track the price of a few specific commodities. Given most commodity prices are correlated, these pairs are lumped together in a general category rather than having clearly differentiated ‘oil’ and ‘iron’ commodity linked currencies, though they can also be described in that way.
The biggest commodity linked currency pairs are any involving the AUD or NZD, the Brazilian Real (BRL) or Russian Rouble (RBL). The South African Rand (ZAR) is also considered commodity linked, though its popularity has suffered somewhat in recent years.
Agricultural commodities exert the biggest influence on the price of the Kiwi Dollar and Brazilian Real, while metals, particularly iron ore and gold, are very important to the Rand and Australian Dollar. The Russian Rouble, when it is traded freely, is closely linked to the price of oil. Normally, a commodity currency will be linked to more than one commodity; for example, the Norwegian Krone (NOK) is linked to both oil and fish prices.
Retail traders can use a specific commodity currency to gain exposure to the price of raw materials or to make bets on the future of industrial growth while avoiding the difficulty and expense of directly investing in the commodity. Where a pair is also linked to a modern diversified economy, you can also expect the price to be less volatile overall.
Exotic currency pairs are those that see relatively low volumes, are not popular with institutional or retail traders, or see large unstable price moves. Not all of these criteria need to apply – the US Dollar / Swedish Krona is an exotic pair because it sees low volumes, not because it shows extreme volatility.
By contrast, the Kenyan Shilling (KES), that nearly halved in value between 2008 and 2020 compared to the USD, is an exotic currency which is both thinly traded and volatile. Traders can often make more profit in volatile markets, but the risks are also compounded.
Even in stable economies such as Switzerland, central bank actions can create rapid devaluations. Many currencies in APAC also are devalued as a deliberate policy to boost their export performance. This is particularly challenging for traders as price adjustments by central banks tend to happen in dramatic overnight swings that may leap straight past your stop loss.
It is safest to avoid exotic currency pairs, unless you are familiar with the market concerned. Proper risk management practice will limit the dangers of volatility and central bank activity.
Restricted and non-convertible currencies
Finally, there is a subset of exotic currencies that have restrictions on foreign dealing. The largest of these is the Indian Rupee, which allows limited exchange, and the onshore Chinese Renminbi (CNY). In the case of CNY a linked offshore currency (CNH) exists that can be traded freely on international markets.
Two currencies – the North Korean Won and Cuban Peso – ban all forex transactions except for very low amounts dealt in person. These are known as fully restricted or non-convertible currencies, and they are not included on electronic trading platforms.
To work around these restrictions, restricted currencies see a trade in price-linked derivatives, denominated in USD, such as non-deliverable forwards. For fully closed currencies there is normally a thriving black market.
What do retail traders need to be aware of?
Whatever currency pair you trade, the most important thing is to be as familiar as possible with it. That means understanding price patterns and any influences on the currency including the national economy and balance of trade.
The most important factors for successful trading of any pair are volatility and liquidity. A highly volatile pair isn’t necessarily a bad thing for retail traders, as it allows for greater utilisation of technical strategies, but a thinly traded one can be a disaster. If a stop loss cannot be closed because there is not enough open interest to make the trade (this is very rare, except for truly vast deals), your losses could become very high indeed.
Asides from avoiding very thinly traded pairs, it is normally good practice to begin by trading your home currency and the USD. Another pair that is popular with technical traders is the USD/JPY, as it responds very well to technical analysis and is known for forming clear chart patterns.
Ultimately, however, any currency pair can work if you put in the time and effort to understand your market. It is true that dealing in more volatile pair types, particularly the exotic, is ‘riskier’, but with proper risk management practice and effective stop losses this can be well mitigated.
Key points to remember
There is no limit to the way you can arrange currencies or groups of currencies, but the most commonly accepted are:
- Major vs Exotic; such as GBP/USD vs USD/KES. Exotic pairs are always more thinly traded and often more volatile too.
- Commodity linked vs not; such as AUD/NZD vs EUR/USD. Commodity linked currencies tend to track the price of commodities, and can be more volatile.
- Fully convertible vs partially restricted; such as GBP/AUD vs USD/INR. Broadly speaking, retail traders should avoid restricted currencies, unless the amount traded is small enough to avoid triggering those restrictions. Fully restricted currencies cannot be traded.
This list is not exhaustive, and a currency can be in one of these groups or several. As an example, the USD/NOK is both commodity linked and an exotic pair. Often the individual characteristics of a currency and its price behaviour are more important than its status as ‘exotic’ or ‘major’.
How Rakuten can help
A better understanding of the particular market environment you are working in can be transformative for your overall trading. If you feel ready to start using your knowledge of pair types without risking any of your capital, why not open a free demo account today?