Most forex traders focus on trading the major and minor currency pairs while totally ignoring exotic currencies. Exotics are lesser known currencies, mainly from emerging and developing nations. Exotic currency pairs represent a massive opportunity for the trader who is willing to tolerate a significant amount of risk and is willing to take some special considerations into account.
The main reason why qualified traders should consider exotic currency pairs is due to their high profit potential. Many exotic pairs are usually inversely correlated to the major currency pairs and as such can provide good trade opportunities whenever the major pairs are not trending.
This article outlines the main characteristics of exotic currency pairs and outlines how to effectively trade such currencies.
What are exotic currency pairs? Here are a few examples:
Characteristics of Exotic Currency Pairs
A defining trait of most exotic currency pairs is that they usually have low liquidity levels. This stands to reason, since they are not traded as frequently as the major and minor currency pairs. Many traders avoid trading the exotic currency pairs because of the high transaction costs associated with such pairs due to their low trading volumes. Only a few banks and traders actually trade such pairs.
In most cases, it is prudent to restrict your trading of a particular exotic currency to the hours in which the financial markets of its home country are open in order to get the best prices and the lowest spreads. Do note that this is quite hard to do when you are trading cross pairs.
Another major challenge faced by most traders in trading exotic currency pairs is the higher spreads associated with them compared to more common pairs. In order to effectively trade such pairs, you should ensure that the profit potential on your trades exceeds the spread by a wide margin.
Exotic currency pairs often display major swings in price, which means that traders who trade them should be prepared for moves that span thousands of pips. This can make them both a tremendous opportunity and risk. Given the large intra-day moves associated with most exotic pairs, it is best to trade exotic pairs by keeping track of short-term indicators. You should be aware that after exhausting a major move, most exotic pairs may trade sideways for a while before another move begins.
Another major drawback to trading exotic pairs is the fact that the financial markets in most emerging nations are not as advanced as those in the developed countries, hence, exotic pairs are considered to be more risky than the major currency pairs.
The financial markets in most emerging countries are characterized by abrupt fluctuations that typically affect the values of their home currencies. Traders should conduct thorough fundamental and technical analysis of the exotic currencies before trading them in order to increase their effectiveness when trading such pairs.
Most experienced traders of exotic currencies follow technical rules to a tee. The reason is that, in many cases, when an exotic pair breaks a key resistance or support level, it is likely to obey the technical rules that align with such breaks. They more closely follow technical rules when compared to major currency pairs, which can be affected by other market forces that may not be part of their core fundamental drivers.
This is not to say that fundamental analysis is not important here – it very much is. Fundamental analysis should be used to predict the most likely future direction, after which technical analysis should be used to confirm your analysis and to properly set up your trades.
Firstly, always keep your trading size within your chosen risk levels. Given the massive moves that exotic pairs can make, you need to protect yourself so that a losing trade does not wipe out your account.
Furthermore, you should always set a wide stop loss distance given the large swings in prices that might knock you out of a profitable trade due to a tight stop loss level. Always allow room for the exotic pairs to move sufficiently before establishing their ultimate trend, which might be in your favor.
Sources of fundamental news, such as news on monetary policy and GDP may not be readily available for exotic currencies. Traders should therefore restrict themselves to trading the exotic pairs that they have an intimate knowledge of in order to minimize their risk exposure.
Before investing in an exotic pair, you should always look for correlations between the currency and related financial assets. For example, when trading the South African rand, it might be prudent to check the current price of gold, given that the country is a major gold exporter. The same is true when trading the Russian ruble, which is correlated to global oil prices, given that Russia is a major oil exporter.
In summary, trading exotic currencies can be an exciting and highly profitable venture, but it can also be risky and there are special considerations into account. Traders should ensure they limit their risk exposure by following the guidelines outlined in this article. The key to effectively trading exotic pairs is to conduct thorough research of their home countries in order to have an intimate knowledge of their economies and the fundamentals that drive such pairs.