Chris as Winner’s Edge Trading did a post a couple months back with suggestions for how to go about picking the best pair or pairs for your forex trading. Essentially, his list came down to a handful of key considerations:
1) Your strategy or analytic methodology
2) Currency correlations and diversification
The list actually has eight factors in it, but I consider several of them to be essentially the same type of consideration. Thus my list of just three.
Let me expand on them.
In terms of #1, you are best off looking at currency pairs which are well suited to the approach you’ll be taking in your trading. Generally speaking, that will either be trend oriented or range-trading oriented. Thus, if you are a trend following trader you are going to be best off working in pairs which have strong trending characteristics in your chosen time frame. Likewise, if you favor a more mean reversion oriented approach, you’ll want pairs that tend toward ranging and/or sharp counter-trend moves.
Note that one currency pair can fall into both categories depending on time frame and market phase. If there are strong underlying factors at work, then in the higher time frames the pair will tend to trend, but maybe in the shorter time frames it may go through ranging periods. These things can and will change over time. As such, it makes sense for you to have a way to identify current market conditions.
If you’re trading primarily the major currency pairs it is very hard to truly have an uncorrelated portfolio of positions. You can only go 3-4 deep with majors and major crosses before you have one currency in multiple pairs, which automatically introduces correlation. And even then, certain currencies will tend to naturally be correlated based on the current economic environment. For example, the CHF and EUR will often be positively correlated because both are impacted by the fundamentals of the European economy.
You can certainly trade multiple pairs which share the same currency (e.g. USD/JPY, GBP/USD, AUD/USD). If so, however, you need to account for that in your risk management strategy. It is highly likely that all the pairs you trade sharing that common currency will move together based on the same factors. That’s great when the market goes in your direction as it will multiply your gains, but the same thing happens with your losses when the market goes the other way.
For the most part, liquidity isn’t a major concern for retail forex traders as your orders will usually get filled at or very close to your order price. Yes, during major news events there can be slippage when trading outside the major pairs and crosses – and even in the majors on occasion. If you’re operating in a higher time frame, though, that’s likely not a major concern.
The bigger consideration here is the cost of trading. The more liquid pairs have narrower bid/ask spreads. That can significantly impact your returns if you’re an active short-term trader, but maybe not so much if you playing the longer-term market moves.
One additional consideration I would add into the mix is how many pairs you should trade. This is a question which comes up a lot in trading forum discussions. To my mind, this all depends on your time frame. If you’re a day trader you’re likely going to want to keep your focus fairly narrow – especially if you’re in and out frequently (e.g. scalping). As you go out the time frames, though, you probably need to be tracking more pairs. It’s simply a function of providing yourself with enough trading opportunities.
In Chris’s post he also mentions personal preference, which I suppose can be an additional factor. If you want to truly be a good trader, though, you should be able to trade whatever market makes the most sense at the time.