When you enter the forex market, you will get a lot of options to choose from for each and every aspect of trading. Having all these options adds to the flexibility of trading and this allows you to make decisions Read More
Because of this new traders tend to be indecisive and often make poor decisions due to insufficient knowledge. The same mistake can happen while choosing your trading instruments in the forex market as you have many options to consider. In this article, I will share some relevant information that can help you choose the best trading instruments as a forex trader along with some tips.
Why do you need to be careful about choosing your forex trading instruments?
When we talk about trading instruments in the forex market, we immediately think about various international currency pairs. These pairs can be classified into 3 categories: major, minor and exotic. The major pairs are the most traded currency pairs and they include USD as the base or quote currency along with another major currency from a developed economy. There are 7 major currency pairs and they contribute the most towards the trading volume. EUR/USD takes the first place when it comes to popularity and trading activities.
Minor pairs do not have USD but have other major currencies paired together. They take the 2nd place in terms of trading volume. Exotic pairs are formed with any major currency paired with the currency of an emerging or developing economy. They have the lowest trading volume out of all pairs. But besides these currency pairs, the forex market also includes indices which allow you to trade a group of fx pairs that have the same base currency. Each currency pair is different from one another and they can also be correlated with one another.
The currency pair that you choose for trading is crucial for shaping your strategy and risk management plan as the number of trading opportunities, profit potential and risk involved are different for each currency pair. So, you can’t expect to make profits without understanding the currency pairs that you are trading in the first place. I will suggest you try out different pairs on your demo account in the initial phase as you get to learn about each pair without risking any money. You can practise trading on any platform, be it MT4 or MT5, but if you want to trade multiple assets, then MT5 would be a more suitable app since it has better features compared to its predecessor.
How can you improve your chances of success by choosing the best trading instruments?
- Liquidity – Earlier, I mentioned the difference in the trading volume of different pairs. Trading volume is directly connected with liquidity which decides the ease with which you can open and close trades. Different currency pairs have different levels of liquidity and it is an important aspect for a trader. For instance, if a scalper tries to trade with an exotic pair with low liquidity that will make trading harder as he/she will struggle to find perfect entry and exit points for their trades. Hence, scalpers always choose the most liquid major pairs as it allows them to enter and exit trades easily.
- Volatility – Volatility in forex can be described as the extent to which a currency pair’s price can move within a specific duration. If a currency pair moves a lot within a short duration, it is considered to be highly volatile and if the price of a pair does not fluctuate much within a short span of time, it has low volatility. Volatility is what gives us trading opportunities and higher profit potential but it also increases the risk of loss. Thus, choosing currency pairs that have enough volatility is crucial for forex trading success.
- Risk – The volatility and liquidity of currency pairs decide the amount of risk that you will be taking while trading with the pair. To cite an example, exotic pairs are considered to be the riskiest as they are highly volatile but don’t have much liquidity. On the other hand, major pairs are considered to be less risky as they are the most liquid out of all pairs. Apart from this, fundamental factors such as economic and geo-political situations should also be considered for determining the riskiness of a pair. Risk and reward cannot be set apart in trading and thus choosing the suitable pairs is important as the exposure to market risk is different with each pair.
- Diversification – Trading with multiple pairs is ideal for mitigating the risk with diversification. One thing that you need to consider while choosing your pairs is the correlation between different pairs. Positively correlated pairs move in the same direction while negatively correlated pairs will be moving in different directions. Hence, choosing the right pairs is important for managing the risk with diversification.
- Trading style and strategy – Not all currency pairs can suit your trading style and strategy. If your trading style demands high liquidity, then you need to choose a pair that fits the criteria well. Similarly, if you follow a long-term strategy like position trading, you need to pick a pair that is more stable and has a lower swap rate. Those who want to make profits from swap with carry trading need to pick pairs that have the perfect interest rate differential for the same.
- Trading session and market activity – The Forex market is different from other financial markets as there are no time constraints associated with trading hours. You can enter and exit trades anytime as per your convenience as the market is closed for weekends and special holidays only. But the liquidity of pairs keeps on changing based on the trading sessions and when you select a trading session based on your time zone, you need to pick pairs that are actively traded at that time.
Tips to Choose the best currency pairs for trading
- Choose pairs that complement your trading goals and trading style- Some currency pairs can perfectly complement a trading style or strategy while other pairs may fail to provide profitable trading opportunities or you may not get the desired results with it. Hence, you need to find currency pairs that suit your trading style and see if they are ideal to trade as choosing the right pairs allows you to attain your profit targets with ease. So, backtest your strategy with different pairs before going live.
- Select pairs based on your risk appetite – Being a forex trader, you must be prepared to take some amount of risk for each and every trade. But you should not be taking excess risk in any situation. To be more clear, traders with a low-risk tolerance should stick to major pairs or minor pairs. They should not be trading exotic pairs as the risk is higher. However, a trader who can afford to take the risk for a higher profit potential may find exotic pairs to be a match for their strategy.
- Trade familiar pairs – Market knowledge is very important for thriving as a forex trader. It takes time to study a pair and sometimes you will have to learn about the economic and geo-political factors that influence the pair. Because a key economic data release or news event can cause sudden volatility which may affect the profitability of your strategy. So, I recommend trading pairs that you are familiar with as it shortens the learning curve. For instance, a trader from Australia will know about AUD to some extent and thus they will be able to trade well with it.
- Consider the trading session – The time at which you can engage in trading should also be considered for choosing the best pairs for yourself. If your schedule goes well with the New York trading session, it will be better to stick with major pairs like EUR/USD actively traded in the session to get enough liquidity. But this is different for each trader as many traders like to trade different sessions for various reasons.
- Trading cost and capital – Trading cost in the forex market includes spreads, commission and rollover fees on overnight positions. So, you need to consider it for optimising your profit potential. Those with a small amount of capital need to stick with major pairs to minimise the trading cost.
Final Thoughts
In the end, the criteria of an ideal trading instrument will be different for each trader but the tips shared in this article can act as a guideline for filtering your options and making a wise choice. So, take your time and pick the best ones.