Cross Currency Spread Trading is a strategy that involves trading the relative price difference (spread) between two currency pairs, often using cross-currency pairs instead of traditional direct pairs (such as EUR/USD or USD/JPY). This strategy focuses on exploiting price inefficiencies between currency pairs that do not involve the U.S. Dollar, commonly referred to as cross currencies (e.g., EUR/GBP, EUR/JPY, GBP/JPY, etc.).

Traders aim to profit from mispricing or divergence in correlation between cross currency pairs, either through spread widening or narrowing. Cross Currency Spread Trading can be market-neutral, allowing traders to take advantage of relative movements in currency pairs without relying on overall market direction.

What Is Cross Currency Spread Trading?

In Cross Currency Spread Trading, traders trade on the price difference between two cross-currency pairs. The idea is that these pairs should maintain certain correlations or historical relationships, and if there is a deviation, a profitable trade can be set up to capture the reversion.

For example, if a trader believes the relationship between the EUR/GBP and EUR/USD pairs will deviate from the historical norm, they can set up a trade that profits from the price correction, capitalising on the spread between the two pairs.

Key Concepts

1. Cross-Currency Pairs

Cross-currency pairs are currency pairs that do not involve the U.S. Dollar as the base or quote currency. Some common examples of cross-currency pairs are:

• EUR/GBP (Euro to British Pound)
• EUR/JPY (Euro to Japanese Yen)
• GBP/JPY (British Pound to Japanese Yen)
• AUD/JPY (Australian Dollar to Japanese Yen)

These pairs are indirect compared to the major pairs like EUR/USD, USD/JPY, or GBP/USD, which involve the U.S. Dollar. Cross-currency pairs may be influenced by the relative movements between their constituent currencies, and the spreads between these pairs can widen or narrow based on macroeconomic factors.

2. Spread between Currency Pairs

The spread in Cross Currency Spread Trading refers to the difference in prices or exchange rates between two currency pairs, particularly cross-currency pairs. Traders look for discrepancies in these spreads to profit as the prices converge or diverge.

For example:

• If EUR/GBP is trading at 0.85 and EUR/USD is trading at 1.18, the relationship between EUR/GBP and EUR/USD can be cross-checked to ensure they maintain historical correlations.
• If EUR/GBP strengthens faster than EUR/USD or vice versa, the trader can set up a long/short strategy to profit from the spread correction.

3. Market Neutrality and Hedging

One of the major advantages of cross-currency spread trading is that it is market-neutral. This means the trader does not rely on the overall direction of the forex market, but instead profits from the relative movement between two cross-currency pairs.

The strategy can also be used as a hedging tool in portfolios that are exposed to multiple currencies, as it allows traders to mitigate currency risk by offsetting movements in one pair with movements in another.

4. Risk Factors in Cross Currency Spread Trading

Several factors can affect the spread between cross-currency pairs:

• Interest Rate Differentials: Central bank policies and interest rate decisions affect the price of currency pairs. For example, if the ECB raises rates while the BoE does not, the EUR/GBP spread may widen.
• Economic Data: Data releases like GDP growth, inflation, or employment figures can drive changes in exchange rates.
• Political Factors: Elections, geopolitical risks, and fiscal policies can influence currency markets and cause correlations to break down temporarily.
• Liquidity and Volatility: Some cross-currency pairs may be more volatile or less liquid than others, increasing the potential for spread fluctuations.

Strategy Setup

1. Identify Correlated Currency Pairs

The first step in cross-currency spread trading is identifying correlated currency pairs that tend to move in the same direction. For example:

• EUR/GBP and EUR/USD: These two pairs are highly correlated because they both involve the Euro (EUR) and tend to move similarly based on the economic conditions in the Eurozone.
• EUR/JPY and GBP/JPY: These pairs share the Japanese Yen (JPY) as the quote currency and often exhibit similar price movements due to Japanese economic factors.

2. Monitor Price Divergence

Once correlated currency pairs are identified, traders will monitor the spread between the two pairs. A deviation from the expected spread can signal a trading opportunity. The trader looks for a widening or narrowing of the spread that exceeds normal volatility or historical norms.

For instance, if EUR/GBP strengthens significantly, but EUR/USD remains stable, the trader may look for a trade that profits from the reversal or correction of the spread between the two pairs.

3. Constructing the Position

To set up the trade:

• Long Position: If a trader expects the spread between two currency pairs to widen (i.e., one currency pair will outperform the other), they can go long on the currency pair they expect to appreciate and short the pair that they expect to depreciate.
• Short Position: Conversely, if the trader expects the spread to narrow (i.e., the difference between the two pairs will converge), they can short the pair that is overperforming and go long on the underperforming pair.

For example, if a trader believes that EUR/GBP will outperform EUR/USD:

1. Long EUR/GBP (buy the Euro against the British Pound).
2. Short EUR/USD (sell the Euro against the U.S. Dollar).

The trade profits if the price of EUR/GBP rises relative to EUR/USD.

4. Exit Strategy

Traders will typically set exit levels for the spread trade, either based on:

• Target profit levels: The trader expects the spread to return to the historical average, and they will exit when this target is reached.
• Stop-loss orders: To manage risk, traders can set stop-loss levels to exit the position if the spread moves unfavourably beyond a certain threshold.

Example: EUR/GBP vs. EUR/USD

Let’s assume a trader expects EUR/GBP to rise relative to EUR/USD due to economic data from the Eurozone. The trader might take the following steps:

1. Long Position: Buy EUR/GBP at 0.8500 (expecting the Euro to strengthen against the Pound).
2. Short Position: Sell EUR/USD at 1.1800 (expecting the Euro to underperform against the U.S. Dollar).

If the Euro strengthens as expected, the EUR/GBP will rise relative to EUR/USD, and the trader can close both positions for a profit.

Tools and Technologies

• Data Feeds: Real-time price feeds from platforms like Bloomberg, Reuters, or other FX data providers.
• Trading Platforms: Platforms such as MetaTrader 5, NinjaTrader, or Interactive Brokers for executing trades in currency pairs.
• Analytics Tools: Use Excel, Python, or R for statistical analysis of historical correlation and spread analysis.
• Backtesting Platforms: Platforms like QuantConnect and Backtrader for testing inter-market strategies.

Advantages

• Market-neutral: The strategy does not depend on overall market direction and can profit from relative price movements.
• Diversification: Cross-currency spread trading diversifies risk across different currencies, reducing exposure to a single market.
• Captures inefficiencies: The strategy capitalises on short-term pricing inefficiencies between correlated currency pairs.

Limitations

• Correlation risk: The correlation between currency pairs may change over time, especially during periods of geopolitical risk or central bank policy changes.
• Liquidity concerns: Some cross-currency pairs may have lower liquidity than the major currency pairs, which can result in higher slippage and difficulty entering or exiting trades.
• Complexity: Requires a deep understanding of currency market dynamics, correlations, and economic factors.

Best Markets for Cross Currency Spread Trading

• EUR/GBP and EUR/USD: These pairs have a strong correlation and are often used in intermarket spread trades.
• GBP/JPY and EUR/JPY: Both pairs involve the Japanese Yen and often move similarly based on Japanese economic conditions.
• AUD/USD and EUR/AUD: These pairs share the Australian Dollar and can be traded together based on Australian economic conditions.

Conclusion

The Cross Currency Spread Trading Strategy offers an advanced way to profit from the relative price movements between correlated currency pairs. By identifying discrepancies in these pairs, traders can set up market-neutral positions that benefit from convergence or divergence in the price spread. However, this strategy requires careful analysis of correlations, market conditions, and economic factors affecting currency pairs.

To learn how to implement Cross Currency Spread Trading strategies, backtest models, and manage risks effectively, enrol in the expert-led Trading Courses at Traders MBA.