A lot of interbank cross trading
volume does not go through the direct cross market, because institutional
traders have a vested interest in hiding their operations from the rest of the
market. In many cases, too, standing liquidity is simply not available in
less-liquid crosses (GBP/JPY or NZD/JPY, for example). So they have to go
through the legs, as the dollar pairs are called with respect to cross trading,
to get the trade done. They also have an interest in maximizing the prices at
which they’re dealing - to sell as high as possible and to buy as low as
possible.
One of the ways they’re able to do
that is to alternate their trading in the dollar legs. For instance, if you
have to sell a large amount of EUR/JPY, you can alternate selling EUR/USD,
which may tend to drive down EUR/USD but also push USD/JPY higher (because U.S.
dollars overall are being bought). You now (you hope) have a higher USD/JPY
rate at which to sell the JPY leg of the order. But selling USD/JPY may push
USD/JPY lower or cap its rise, leading EUR/USD to stop declining and recover
higher, because U.S. dollars are now being bought. Now you have a slightly better
EUR/USD rate to keep selling the EUR leg of the order. By alternating the
timing of which U.S. dollar leg you’re selling, you have (you hope) executed
the order at better rates than you could have directly in the cross and likely
managed to obscure your market activity in the more active dollar pairs.
Of course, it doesn’t always work
out as neatly and cleanly as what we just described. The net result in the
market is a steady directional move in the cross rate, while the USD pairs
remain relatively stagnant or within recent ranges. Be alert for such
dollar-based movement, and consider that it may be a cross-driven move and a
potential trading opportunity.
Cross-rate movements can also
have a pronounced effect on how individual dollar pairs move in an otherwise
dollar-based market reaction. Let’s say some very USD-positive news or data has
just been released, and the market starts buying USD across the board. (We
focus on buying USD/JPY and selling EUR,/USD in this example.) If USD/JPY
happens to break a key technical resistance level, it may accelerate higher and
prompt EUR/JPY to break a similarly significant resistance level, bringing in
EUR/JPY buyers. The net effect in this case is that EUR/USD will not fall as
much or as rapidly as USD/JPY will rally, because of the EUR/JPY cross buying.
If you went short EUR/USD on the positive U.S. news, you may not get as much
joy. But the legs also tend to move in phases, and continued EUR/USD selling
may eventually break through support, sending EUR/JPY lower and capping USD/JPY
in the process.
As you can see, crosses can
affect the market in virtually limitless ways, and there’s no set way these
things play out.
When the U.S. dollar is not the
primary focus of the market’s attention, or if major U.S. news is approaching
(like a non-farm payrolls [NFP] report or a Federal Open Market Committee
[FOMC] decision in a few days), sending market interest to the sidelines,
speculative interest frequently shifts to the crosses. Always consider that the
market‘s focus may be cross-driven rather than centered on the USD or any other
single currency. Some days it's a dollar market, and other days it's a cross
market. GBP may be weakening across the board on weak UK data, but if the USD
is similarly out of favor, the pound’s weakness is likely to be most evident on
the crosses.
When looking at cross-trade
opportunities, you may be tempted to translate the cross idea into a USD-based
trade. You may think that AUD/JPY is forming atop, for example. If you're
right, you may be thinking that one of two moves is likely USD/JPY will move
lower or AUD/USD will move lower - and you may be tempted into selling one of
the legs (AUD/USD or USD/JPY) because you don’t want to get involved in a
cross. But there's another possibility: One leg may go down precipitously while
the other moves higher, sending the cross lower, as you expected. But if you
went short the wrong leg, you missed the boat.
When you spot a trade opportunity
in a cross, trade the cross. Don’t try to outguess the market and pick which
component will make the cross move. Trust that if your trade analysis is
correct, the cross will move the way you expect.
