Synthetic pairs are currency pairs that do not exist in the traditional forex market but are created by combining two or more existing currency pairs. Traders can use synthetic pairs to gain exposure to a new currency relationship without directly trading the pair in the spot market. These pairs are typically constructed by combining the movements of two different currency pairs and applying mathematical formulas to establish a synthetic exchange rate.

The concept of synthetic pairs is useful in situations where a direct forex pair might not be available or when traders want to take advantage of specific market conditions that are not captured by existing pairs. Synthetic pairs can also be used in more complex trading strategies, including arbitrage, hedging, or speculation on indirect relationships between currencies.

How Synthetic Pairs Are Created

Synthetic pairs are typically created using two existing currency pairs and their exchange rates. For example, a trader may want to create a synthetic pair between two currencies that don’t have a direct market. By combining two existing currency pairs, the trader can effectively create the synthetic pair.

For instance:

• To create a synthetic pair of EUR/JPY (Euro to Japanese Yen) when the EUR/JPY pair is not available directly, a trader can combine the EUR/USD and USD/JPY pairs:
  • EUR/JPY = EUR/USD × USD/JPY

In this case:

• EUR/USD represents the exchange rate of the euro against the U.S. dollar.
• USD/JPY represents the exchange rate of the U.S. dollar against the yen.

By multiplying these two exchange rates together, you get the synthetic EUR/JPY exchange rate.

Examples of Synthetic Pairs

1. EUR/GBP (Euro to British Pound)
   • If you want to trade the euro against the British pound but don’t have access to the EUR/GBP pair directly, you could create a synthetic EUR/GBP using the following formula:
     • EUR/GBP = EUR/USD ÷ GBP/USD
2. GBP/JPY (British Pound to Japanese Yen)
   • A synthetic GBP/JPY pair can be created by using:
     • GBP/JPY = GBP/USD × USD/JPY
3. AUD/JPY (Australian Dollar to Japanese Yen)
   • To trade AUD/JPY, a synthetic pair can be created using:
     • AUD/JPY = AUD/USD × USD/JPY

How to Trade Synthetic Pairs

1. Arbitrage Opportunities:
   • Synthetic pairs can be useful in arbitrage strategies, where a trader exploits price differences between the direct and synthetic pairs. If the price of a synthetic pair diverges from the actual exchange rate in the market, an arbitrage opportunity exists.
   • Example: If the synthetic EUR/GBP pair, created using EUR/USD and GBP/USD, is trading at a different price than the direct EUR/GBP pair, traders can buy the cheaper pair and sell the more expensive one to lock in a profit.
2. Exposure to Multiple Currencies:
   • Synthetic pairs allow traders to gain exposure to multiple currencies at once, even if a direct forex pair is not available. For example, by trading synthetic EUR/GBP, a trader is effectively trading both the EUR/USD and GBP/USD pairs simultaneously, which can increase the potential for profit or loss.
3. Hedging Strategies:
   • Synthetic pairs are often used for hedging purposes. A trader can hedge their exposure to a particular currency by taking opposite positions in synthetic pairs. For instance, if a trader is long on the EUR/USD and short on the USD/JPY, they can hedge their position by creating a synthetic EUR/JPY position.

Advantages of Synthetic Pairs

1. Access to Unavailable Pairs:
   • Synthetic pairs allow traders to gain exposure to currency pairs that may not be available directly through their broker. This is particularly useful for trading exotic currency pairs or currency combinations that have limited liquidity in the market.
2. Flexibility in Trading:
   • By creating synthetic pairs, traders can take advantage of indirect currency relationships and market movements that might not be captured by direct pairs. This adds flexibility in constructing trading strategies.
3. Arbitrage and Risk Management:
   • Synthetic pairs can be part of an arbitrage strategy, where traders exploit price discrepancies between the direct pair and synthetic pair. They can also be used for risk management by allowing traders to hedge positions across different currency pairs.

Disadvantages of Synthetic Pairs

1. Calculation Complexity:
   • Trading synthetic pairs requires a solid understanding of how to calculate the exchange rate and manage the calculations. Some traders may find the process complex and time-consuming, especially when managing multiple synthetic pairs.
2. Spread and Liquidity Issues:
   • Synthetic pairs may have wider spreads and less liquidity compared to directly traded currency pairs, which can increase the cost of trading and make it more difficult to execute orders at desired levels.
3. Market Volatility:
   • Synthetic pairs can sometimes be more volatile than directly traded pairs, particularly if one of the underlying pairs is highly volatile or has low liquidity. This can lead to greater risk for traders.
4. Execution Delay:
   • As synthetic pairs are not directly quoted by brokers, there may be a slight delay in execution due to the time it takes for the system to calculate the synthetic exchange rate. This delay could potentially lead to slippage or missed opportunities in fast-moving markets.

Practical Example: Creating a Synthetic Pair

Let’s say you want to trade AUD/GBP but your broker doesn’t offer this direct pair. You can create a synthetic AUD/GBP by using the following formula:

1. Find the exchange rates for the individual pairs:
   • AUD/USD = 0.7400 (Australian Dollar to U.S. Dollar)
   • GBP/USD = 1.3200 (British Pound to U.S. Dollar)
2. Create the synthetic pair:
   • AUD/GBP = AUD/USD ÷ GBP/USD = 0.7400 ÷ 1.3200 = 0.5606
3. Trade the synthetic AUD/GBP pair:
   • Now, you can enter trades on this synthetic AUD/GBP pair by monitoring the value calculated from the above formula.

FAQs

What are synthetic pairs in forex?
Synthetic pairs are currency pairs that are created by combining two existing currency pairs. They allow traders to gain exposure to currencies that do not have a direct trading pair available.

How do I trade synthetic pairs?
To trade synthetic pairs, you need to combine two existing currency pairs using a mathematical formula. You can enter long or short positions based on the synthetic exchange rate, just as you would with a direct currency pair.

Why would I trade synthetic pairs?
Traders may choose synthetic pairs to gain exposure to currency combinations that are not offered by their broker, take advantage of arbitrage opportunities, or hedge positions across multiple currency pairs.

Can synthetic pairs have the same liquidity as direct pairs?
No, synthetic pairs typically have lower liquidity compared to direct currency pairs, which can result in wider spreads and higher trading costs.

Are synthetic pairs suitable for beginners?
Synthetic pairs are more advanced and require a good understanding of how exchange rates are calculated. They may not be ideal for beginners, but they can be a powerful tool for more experienced traders.

Conclusion

Synthetic pairs are a useful tool for forex traders, enabling them to trade currency combinations that are not directly available on their broker’s platform. They offer increased flexibility, access to unavailable currency pairs, and can be used for strategies like arbitrage or hedging. However, they come with some complexities, such as the need for calculation, lower liquidity, and potential volatility.