Exotic Currency Pairs and Why It Is Better to Avoid Them
As you know, we follow several currency pairs plus gold and silver because trade the longer time frames (daily, weekly and monthly). The currency pairs we follow are all regular main currency pairs. However, we are frequently asked why we don&8217;t follow the exotic currency pairs like USD/HKD. I am writing this article to explain what exotic currency pairs are and why I prefer not to trade them.
As you gradually gain confidence in your Forex trading, the need and the want to experiment is quite natural. One of the first ports of experimental trade is the exotic currency transactions. Yes, as the name suggests, I am talking about the lesser known, relatively less traded currency pairs that many Forex traders choose to invest in hoping that it might make more profit. Sometimes the need to do something different and unique pushes the Forex trader towards these exotic and unusual currency pairs because they look more promising at the beginning.
But, before we proceed any further, it is extremely important to understand the basics of these exotic pairs and the associated risks.
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What Are the Exotic Currency Pairs?
Here is the list of the most famous exotic currency pairs:
Currency Pair Symbol
Name of the Involved Currencies
|USD/NOK||US Dollar and Norwegian Krone|
|USD/SEK||US Dollar and Swedish Krona|
|USD/DKK||US Dollar and Danish Krone|
|USD/TRY||US Dollar and Turkish Lira|
|USD/ZAR||US Dollar and South African Rand|
|EUR/NOK||Euro and Norwegian Krone|
|EUR/SEK||Euro and Swedish Krona|
|EUR/DKK||Euro and Danish Krone|
|EUR/TRY||Euro and Turkish Lira|
|EUR/ZAR||Euro and South African Rand|
Essentially currencies in the forex market can be divided into three subparts. First and foremost you have the ‘major’ currency pairs. These are the currencies of the major countries paired against the US dollars. Some examples are Euro, Pound Sterling and the Australian Dollar. The next in the list is ‘crosses’. These are major currency pairs but are not paired against the US Dollar, like EUR-CHF. Next and the final group is the Exotic currency pairs.
The most common definition of exotic currency pairs would be the not so commonly traded foreign currency and is usually from some European countries like Denmark and Norway and the developing countries across Africa, Asia and the Middle East like the Turkish Lira, the Mexican Peso and the Brazilian Real.
These currency pairs are not considered as major currency pairs in Forex market trade and trading them could be quite challenging in a standard brokerage account. Quite unlike the major currencies like the US Dollar or the Euro, these entities are relatively less tracked by market analysts and the depth of trade is significantly lower in this case.
As you would gather from the name exotic itself, the uncertainty factor is way higher in these compared to the major currencies or the currency crosses in the market. Most cases this type of currencies are intrinsically linked to the existing economic and the political situation of the country and are quite susceptible to potential changes in the eco-political developments in the region.
Needless to mention that this also increases the risks associated with these currencies. However, for many, this is the additional charm of the exotic currencies. As the old forex market adage goes, ‘higher the risk, higher the reward.’ So for many who are keen on making it big in the forex market, this is their shot at making some quick bucks without any major analysis or effort. They trade it on the expectation of garnering higher returns given the risks associated with trading these currencies. However, usually these traders are among the ones who wipe out their accounts because the way they trade is more similar to gambling than trading.
Another interesting element that attracts some traders to exotic currencies is that the relatively low volume makes price action in these currencies a lot more predictable compared to the major currencies. The pace if trade is way faster in major currencies and as a result of that the price action is lot more unpredictable and at a decidedly faster rate.
Sometimes much stronger trade setups form with these pairs while there is no trade setup with the other currency pairs for such a long time, and this can make you trade these pairs, because you been waiting for such a long time for a strong trade setup to form with the other pairs. But usually when a major currency pair like USD/CHF forms a trade setup, an exotic currency pair like USD/DKK, USD/SEK and USD/NOK also form the same trade setup.
Key Features Of Exotic Currency Pairs
So now that we understand the basic definition of exotic currencies, here are some key features that distinguish them from the currency majors and the crosses available in the factor.
1. Uncommon and Uncertain
Most standard brokerage accounts would not offer trading in these currencies. Just a handful give you the option to actually trade in these and that to you need to understand the norms governing trade in these currencies. News in the public domain is also scarce and very little is known about the dynamic that drive these currencies and their potential return portfolio.
2. Thin Market Condition
Given the relatively low interest in these currencies, they are thinly traded in the market and generally register significantly lower volume in comparison to the major currency pairs. Reach is also a key factor that impacts the volume of these currencies. Not many brokerages offer traders the option to trade in these. This too has a direct bearing on the volume and the liquidity aspect of trading in these currencies.
3. The Eco-political Connection
Most of these exotic currencies belong to the developing countries and at times some of the closed economies in the world. As a result of this, these exotic currencies are intrinsically linked to the economic and political developments of the country they represent. Any change in the economic or the political situation in these countries has significant bearing on the overall performance of the currency and how trade pans out in these in the future.
As a result of this, any investment in these currencies are always advised only after in-depth understanding of the economic and political dynamics of the associated country.
Pros & Cons of Trading in Exotic Currency Pairs
Seldom is there a situation in the forex market when the scale is so severely titled towards one end of the spectrum and trade seems so dependent on a handful of factor as we notice in case of exotic currencies. The disadvantages and risks associated with exotic currencies are way higher, and it is for this reason that many a times forex market veterans advise against investing in these. First a look at some of the advantages:
Advantages of Trading in Exotic Currencies
1. Greater Predictability
Give the low volume and significantly slower pace of trade, the price action is far more predictable. The pip wise movement, as well as unfolding of a trade pattern, is quite easily discernible in the case of these exotic currencies. Compared to the major currency pair, the uncertainty in potential trend formation is way lower and hence it can make way for significantly long lasting trades.
2. Limited Traders
The huge abyss of ignorance, the relatively low exposure of the forex trading community and the significantly higher transaction costs coolly eliminates the scope of speculators and non-serious players in the ambit of exotic currency trade. Only those who are confident, committed and have the wherewithal to fund these relatively high-cost transactions.
3. Opportunity To Diversify
As is most commonly noticed, this kind of trade mostly attracts seasoned money market traders and fund managers looking to diversify. It gives them the scope to try out something that is novel, never tried before and with a relatively high degree of profit if the trade works out to their advantage. This, in turn, makes helps in optimizing their lure for all those forex market practitioners who might be confident about executing these kinds of trades. The relatively long trending period gives them the scope to meaningfully add to their portfolio through these diversification moves and boost the profit prospect significantly through the calculated risks that they choose to take.
4. Challenging Opportunity
The uniqueness of it also lends a hugely challenging opportunity for an experienced forex trader. Not only do they get to experiment in something unique but also it opens up the prospect for them to tread some untraded territory and evolve a winning formula that could well be a testimony of their trading expertise too. It creates a pocket for bringing in some unprecedented gains on the back of one good trading strategy backed by strong news development.
Disadvantages of Trading in Exotic Currencies
However, most times the associated risks with trading these currencies are so huge that the advantages are overshadowed by the disadvantages and the concerns that forex traders have with regard to these.
1. Very Thin Volume
The lack of interest and understanding deal a double whammy for the exotic currencies. Both these factors lead to very thin volumes being traded on a daily basis, and this thin volume has a significant bearing on the volatility, price action and risk factors that go with trading these counters. The low volume also results in the lack of market depth in these trades and hence the scope of a lasting base and strong support and resistance zones is relatively weak. The low volumes also impact the liquidity factor accordingly and have a deep bearing on the margins of loss and profit that can be associated with these trades.
2. Large Bid-Ask Spread
Another key disadvantage in trading these exotic currencies is the fact the spread between the bid and the ask price can be really huge, at times as high as 50 pips compared to just 2-3 pips in some of the major currencies during the course of daily trade. The direct fallout of this is the huge cost associated with it and also the risk factor becomes significantly huge when you set to trade a counter with that high spreads.
3. Limited Research
These are by far the least popular choice of trade among most forex traders. As a result, you have very limited analysis and research material available for these currencies. There is also a possibility that whatever little research that might be available could have a decided tilt or bias in it. Given the lack of understanding, there is no way to double check this information either. So the choices as a forex trader are significantly limited for you. Either you go with it, or you ditch the trade completely.
4. High Transaction Cost
Given the low popularity and huge risks involved, the cost of executing these trades are huge and many times the cost factor is significantly forbidding for many small time player. The high initial cost and the huge uncertainty factor that are associated with trading these exotic currencies spike up the overall cost of transaction so much that it kinds of act as a negative pull and dissuades many potential traders from take constructive steps towards fructifying any trade in these currencies.
Potential Risks of Trading in Exotic Currencies
While whatever points we might list out either supporting this kind of trade or negating any investment in it, without the help of suitable practical illustration it is difficult to understand or agree to any bit of it. Let us, therefore, understand the practical risk of dealing in this kind of currency trade as a regular forex market trader.
I am sure all of you remember the Asian Currency Crisis in late 1990s. It is a classic example of how wrong a trade in these exotic currencies can go wrong. The entire crisis started when the Government in Thailand had to change its fixed exchange rate with the US Dollar for the Thai Baht. The Government in Thailand had no option but to float the Baht and let the market determine the fair value.
As a result of this move, the currency collapsed, and the spillover effect was seen in many currencies across South East Asia. Now imagine the kind of losses that all those who held positions in these currencies had to suffer. Given the extent of spreads, the margin if risks and leverage worries, the related loss was way higher than anticipated, and the after effects of these were felt world over.
The other example is related to the Russian Ruble recession. Most brokers stopped accepting any USD/RUB orders because of the huge down movement. Of course, this is what market maker brokers did because they did not want to pay for the huge profit made by those traders who went short:
While you might argue that the essence of forex market trade is taking calculated risks and letting it reap benefits for it, I would also add that as you sow, so shall you reap. What I mean by this is while the profit potential of good and favorable currency market trade is undeniably huge, you can in no way ignore the risk factor which weigh significantly on these transactions despite the lure of the returns.
The economic and the political factors that impact these currencies is by far the biggest risk associated with it. You as a forex trader have no control over all what dictates the economic development in the country. No country will tweak its economic policies in the interest of a few handful forex traders either. Similarly, the factors governing a politics is completely divergent from the needs and requirements of what makes for a successful forex trade. Political upheavals are not uncommon in most emerging and developing nations, and the resultant economic changes can have huge implications on your trading positions. Neither do you have a say in this nor is there any avenue for redressal.
The valuation is my final point of concern with regards to trading in exotic currencies. The lack of research and market depth makes it nearly impossible to reach the fair value zone or even decide what could be an absolute value for this kind of a currency. Even then, the resultant value has its associated uncertainty factor. Many times, the overvaluation in these results in creation of bubbles in these exotic currencies further is enhancing the loss prospects and the resultant risk emanating as a result of investing in this kind of currency trade.
Thus, I would say it is best to avoid investing in this kind of trade because the risks and loss prospects far outweigh the returns and profits expected fro execution of a trade of this stature.
How Professional Traders Trade the Exotic Currency Pairs
Professional traders don&8217;t trade the exotic currencies through the retail Forex brokers and the currency pairs that the other traders use. They trade through the banks and through a very different approach. Some of them use the local events to buy and sell currencies against each other to make money.
For example, in 2006 when the 33 days war was finished, some professional investors bought the Lebanese pound because its value was depreciated dramatically at end of the 33 days war. However, everybody knew that when the war was stopped, the currency would recover gradually. So they bought the Lebanese pound, hold it and then sold it when it reached near the value it had before the 33 days war.
This is a genius way to trade the exotic currencies that even most people don&8217;t know they exist.