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Master Class: How to Use Crosses to Trade Spot FX
If I told you that there was a large order in the market to buy EUR and sell GBP would you be looking to sell EURUSD and buy GBPUSD, do the opposite or step aside as the order gets executed? As outsiders, we are not privy to the flows in the market and due to increased regulation, banks that are executing the orders no longer pass on the information. All we are left with is guesswork but the price action in major crosses, such as EURGBP, EURJPY, GBPJPY, etc. can give a clue to the cross flows and how to use this information to trade spot fx.
Dollar centric world
When I first started trading in the forex market it was a dollar centric world. In other words, the dollar was the center of all transactions and currencies rarely moved in opposite directions from one another. Most times currencies moved in the same direction as the prevailing dollar trend but not with the same pace. So, for example, if there was a EURGBP sell order (in those days it was GBPDEM) and the dollar trend was up, both EURUSD and GBPUSD would both move down but the EURUSD would move farther and faster than the GBPUSD.
What is a cross?
Before I go on to the current trading world, let me define a cross in forex trading. A cross is defined by the relationship between two currencies. It is simple algebra. There are two variables and one product which do not directly involve the dollar as that portion gets netted out.
Example 1: EURGBP is calculated by EURUSD/GBPUSD = EURGBP. Let’s say EURUSD is trading at 1.1850 and GBPUSD at 1.2950. Then EURGBP = 1.1850/1.2950 = .9151.
Example 2: EURJPY is calculated by EURUSD x USDJPY = EURJPY. Let’s say EURUSD is trading at 1.1850 and USDJPY at 106.10. Then EURJPY = 1.1850 x 106.10 = 125.73
The difference in the calculations where we divided the two currency pairs in example 1 and multiplied in example 2 is the way each currency pair is quoted vs. the US dollar. For example, EUR and GBP are quoted as dollars per one EUR (or GBP) while USDJPY is quoted as Japanese Yen per one US dollar. In all cases, the dollar portion is netted out and you are left with one currency vs. another with no US dollar component.
Trading in a on-dollar centric world
However, this does not mean, as you will soon see, that the dollar is not impacted by a cross trade as the market has to go into and out of the dollar (as the case may be) to create the cross.
Now, we no longer live in a US dollar centric trading world but a multi-currency world. What I mean by that is while the dollar is still the dominant trading currency, cross-currency flows have become a large part of forex trading and more often than not drive the spot fx market. It is a rare time that the dollar moves in the same direction against all currencies.
How to use crosses to trade the USD
So the question is, how do you take advantage of cross flows to trade spot fx, even if you do not trade the crosses directly? In other words, you do not have to trade crosses but you can use the information gleaned from them to your advantage while trading a spot currency, such as EURUSD or GBPJUSD.
Let’s say there is a flow in EURGBP to buy EUR and sell GBP in a market where the overall dollar trend in both is up. By looking at EURGBP, you may assume there is buying of EURUSD and selling of GBPUSP to execute an order. In this example, the overall dollar trend is up but more so vs. the GBP than vs. the EUR. The EURUSD initially trades higher and GBPUSD tries to follow as the order gets executed. The EURUSD buying is easily absorbed as there are willing sellers as the trend is down in this currency vs. the dollar. Once EURUSD hits resistance, the GBPUSD sell component of this flow takes over and GBPUSD falls sharply.
Why? The answer is because the market has less capacity to absorb the GBPUSD selling than the EURUSD buying to execute the buy order in EURGBP. Once the order is completed and/or EURGBP meets resistance, EURUSD will lose its cross related bid and will fall as well should the dollar move higher.
If the dollar was in an overall downtrend, (e.g. EURUSD was in a strong uptrend) and that was the dominant side, GBPUSD may have initially dipped on EURGBP buying but would not have gone that far. EURUSD demand out of this cross flow would have then taken over and pushed it higher as that was the side where flows were less easily absorbed.
Crosses can give a clue for spot trading
As we all know, trading rarely works like a textbook but in this simple example, you can see how crosses can give a clue to trading spot fx. They tell you what flows are going through the market in what can often look like a tug-of-war with respective currencies pulling in opposite directions. When you see two currencies moving in opposite directions vs. the dollar it is a clear sign that a cross flow is being executed in the market and that is likely driving the price action in each pair. As a general rule, one currency will have less capacity to absorb the flows and this is the side of the cross trade that tends to be most vulnerable.
This just scratches the surface but should give you an idea how to use crosses to trade spot fx. The following videos, which I created some time ago, will further emphasize these points with real-time illustrations.
How EURGBP Drives EURUSD and GBPUSD
Sign up for The Amazing Trader
Using EURGBP to Trade EURUSD and GBPUSD
Sign up for the AT Ladder Strategy Guide
Jay Meisler, co-founder Global-View.com
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