Synthetic forex pairs are not traditional currency pairs like EUR/USD or GBP/JPY. Instead, they are constructed by combining two or more existing currency pairs to create a new trading instrument.

For example, a synthetic forex pair might be created by combining EUR/USD and USD/JPY to form a new pair like EUR/JPY. This method allows traders to access currency pairings that are not directly available on the forex market.6

These pairs, which are not directly traded on the forex market but are created from other currencies, offer unique opportunities for diversification and strategic advantage.

How to Trade Synthetic Forex Pairs

1. Understand the Basics of Synthetic Forex Pairs

Before going into trading, it’s essential to understand the concept of synthetic forex pairs. These pairs are not directly traded but are created by combining the exchange rates of existing currency pairs.

For example, the synthetic pair EUR/JPY can be formed by dividing the EUR/USD rate by the USD/JPY rate. Understanding how these pairs are constructed and their market behaviour is necessary for effective trading.

2. Choose Your Synthetic Pairs

Identify which synthetic forex pairs align with your trading goals and market outlook. You can create synthetic pairs based on your analysis of various currency pairs.

For example, if you expect the Euro to strengthen against the Yen, you might consider trading a synthetic EUR/JPY pair.

3. Analyze Market Conditions

Perform a thorough market analysis to evaluate the potential of your chosen synthetic pairs. This includes:

Technical Analysis: Use charts, indicators, and patterns to assess the price movement and trends of the synthetic pair. Fundamental Analysis: Consider the economic factors and news events affecting the underlying currencies of the synthetic pair. This will help you to understand how external factors might influence the synthetic pair’s performance.

4. Develop a Trading Strategy

Formulate a trading strategy specific to synthetic forex pairs. This should include:
Entry and Exit Points: Determine where you will enter and exit trades based on your analysis. For example, you might enter a trade when the synthetic pair shows a favourable technical signal or economic indicator.

Stop-Loss and Take-Profit Levels: Set stop-loss orders to limit potential losses and take-profit orders to secure gains. Adjust these levels based on the volatility and behaviour of the synthetic pair.

5. Monitor Liquidity and Spreads

Check the liquidity and spreads of the synthetic forex pairs you intend to trade. Synthetic pairs may have varying levels of liquidity compared to traditional pairs and this can impact execution and pricing. Ensure that the spread is acceptable and that there is sufficient market depth to handle your trade size.

6. Implement Risk Management

Avoid overexposing your account by managing the size of your trades relative to your total capital. Use synthetic pairs to diversify your trading portfolio and spread risk across different market dynamics. Continuously review and adjust your trading strategy based on performance and changing market conditions.

7. Utilize Trading Platforms and Tools

Leverage trading platforms and tools that support synthetic forex pairs. Many advanced trading platforms allow you to create and monitor synthetic pairs, perform technical analysis, and execute trades. Get yourself used to these tools to enhance your trading efficiency.

8. Stay Informed and Adapt

The forex market keeps changing with time, and conditions also varies rapidly. Stay informed about market developments, economic events, and geopolitical factors that might affect your synthetic pairs.

Be prepared to adapt your strategy based on new information and evolving market conditions.

How Are Synthetic Forex Pairs Created?

Creating synthetic forex pairs involves a straightforward mathematical process. Traders use the exchange rates of existing currency pairs to derive the value of the synthetic pair. The formula typically used is:

Synthetic Pairs = Currency Pair A ÷  Currency Pair B

For example, to create the EUR/JPY synthetic pair, you would divide the EUR/USD exchange rate by the USD/JPY exchange rate. This approach provides a new perspective on currency movements and allows traders to exploit potential inefficiencies in the market.

Benefits of Trading Synthetic Forex Pairs

1. Diversification of Forex Pairs

Diversification is a principle in trading and investing that helps spread risk and potentially enhance returns. Synthetic forex pairs offer different ways to achieve diversification beyond the traditional currency pairs available in the forex market.

By creating synthetic pairs, traders can combine currencies in ways that are not directly offered by standard forex pairings.

For example, if a trader is primarily focused on major pairs like EUR/USD and GBP/USD, they might miss out on opportunities arising from cross-currency movements that involve lesser-known or exotic currencies.

Synthetic pairs can bridge this gap by allowing traders to construct pairs that involve combinations of currencies from different regions or economic conditions.

2. Arbitrage Opportunities

This involves exploiting price differences between markets or instruments to achieve risk-free profits. Synthetic forex pairs can create unique arbitrage opportunities by revealing discrepancies between actual market rates and the theoretical rates derived from combining existing pairs.

Consider a scenario where a synthetic pair, such as EUR/JPY, is created by dividing the EUR/USD rate by the USD/JPY rate. If the synthetic EUR/JPY rate derived from this formula deviates significantly from the actual market EUR/JPY rate, an arbitrage opportunity may exist.

3. Enhanced Flexibility

One of the standout benefits of synthetic forex pairs is the flexibility they offer in trading strategies. Traditional forex pairs are constrained by the available combinations offered by the market.

In contrast, synthetic pairs allow traders to create new pairings that align more closely with their market outlook or trading strategy.

For example, if a trader expects the Euro to strengthen against the Yen but is also concerned about the volatility of the USD, they could create a synthetic pair that isolates this expectation from USD fluctuations.

4. Cost Efficiency

Trading multiple currency pairs individually can lead to increased transaction costs, including spreads and commissions. Synthetic forex pairs can help consolidate trades and potentially reduce these costs.

By using synthetic pairs, traders can achieve the same exposure with fewer trades.

For example, rather than trading EUR/USD and USD/JPY separately, a trader could create a synthetic EUR/JPY pair to consolidate their positions into a single trade. This can streamline the trading process and potentially lower overall transaction costs.

Common Mistakes to Avoid in Synthetic Forex Pairs

1. Overcomplicating Trades

While synthetic pairs offer unique opportunities, they can also complicate trading strategies. Traders should avoid overcomplicating their trades and stick to a clear and concise strategy.

2. Ignoring Market Conditions

Synthetic pairs are not immune to market volatility. Traders should consider current market conditions and potential risks before trading synthetic pairs.

3. Lack of Understanding

Understanding the construction and behavior of synthetic pairs is crucial. Traders should thoroughly research and comprehend how synthetic pairs are created and how they might react to market changes.

Frequently Asked Questions

1. What makes synthetic forex pairs a unique trading opportunity compared to traditional pairs?

Synthetic forex pairs offer a unique trading opportunity because they allow traders to combine existing currency pairs to create new trading instruments that are not directly available on the market.

This can provide fresh insights into currency relationships, reveal arbitrage opportunities, and enable more tailored trading strategies based on specific market conditions or economic forecasts.

Unlike traditional pairs, synthetic pairs can offer different dynamics and diversification that might not be apparent in standard forex trading.

2. How can I accurately create and analyze synthetic forex pairs to enhance my trading strategy?

Accurately creating and analyzing synthetic forex pairs involves understanding the mathematical formula used to derive them and applying both technical and fundamental analysis.

To create a synthetic pair, you’ll combine the exchange rates of existing pairs (e.g., EUR/USD and USD/JPY to form EUR/JPY). Use trading platforms and tools that support synthetic pairs to analyze price movements, trends, and market conditions.

3. What are the potential risks of trading synthetic forex pairs, and how can I manage them effectively?

Trading synthetic forex pairs involves specific risks, such as lower liquidity, potential pricing discrepancies, and increased complexity compared to traditional pairs.

To manage these risks effectively, it’s crucial to implement robust risk management strategies, such as setting appropriate stop-loss and take-profit levels, diversifying your trades, and regularly reviewing your trading strategy.

Conclusion

Synthetic forex pairs offer a unique and strategic advantage for forex traders looking to diversify their trading strategies and explore new market opportunities.

By understanding how these pairs are created and applying them effectively, traders can enhance their trading strategies and potentially achieve better results.

As with any trading strategy, it’s essential to approach synthetic pairs with a well-informed mindset and a clear strategy to maximize their potential benefits.