Trading 101: Utilizing Currency Pairs in Investing and Trading

As we wrote in our previous look at fiat and cryptocurrency pairs, you can benefit from the properties of exchange rates n several ways. No matter if you are primarily a trader or an investor, it’s essential for you to be familiar with some of the simple methods in order to optimise your strategies and maximise your returns.

Fiat Currencies

In the fiat world, the most important things that affect the value of currencies are interest rates, economic growth, and inflation. Trust is another crucial element, as the “value” of fiat currencies is based on the faith that the currency will be there going forward without losing purchasing power. The value of money also comes from the traditional functions that it serves in the economy:

The three functions of money (Source:disinfo)

Currencies generally move slowly, with a 1% daily change already being considered a significant move. That said, in times of crisis, fiat currencies can quickly lose their value if the faith in them crumbles, destroying the savings denominated in them and jeopardising economic transactions in the territories that use them. Besides the traditional functions of money (store of value, medium of exchange, unit of account), international exchange rates give a new dimension to currencies with several different ways of profiting from them (with the risk of losing money as well).

The most common ways are:

  • Hedging investments in different currencies
  • Speculative positions, forex trading, usually using leverage because of the small movements
  • Benefiting from interest rate differentials (carry trade)
  • Covering exposures and expenses in different currencies; personal hedging

Cryptocurrency pairs

When it comes to crypto-coins, there are several huge differences. First of all, volatility is much higher in them, liquidity is lower (for now), and that has a profound effect on the price movements of the currencies, as well as the most successful strategies that investors should consider. As central banks are constantly destroying the “store of value” function of traditional currencies through inflation, the likes of Bitcoin, Litecoin and Ethereum are even superior in that regards. Also, the coins all have very important usability features that could define the demand for the tokens and their expected future values in addition to their value that comes from their traditional “money” functions.

That said, some of the usage methods of the crypto-pairs are similar to fiat currencies, although the investment component of these positions transforms it to a whole different playing field. Why? Because if you invest in crypto-pairs, so you hold your investments in crypto pairs (not to be confused with buying tokens with other coins such as Bitcoin), you are always betting on the relative performance of the two currencies and that can be a lot different from the performance in fiat terms. This is especially true when trading with leverage. But what is the difference exactly? Let’s see what the case is regarding the different investment/trading methods.

Investing in one or more coins through holding the coins

In this case, your position is simple. You have an exact amount of the various coins that can be changed at any time to other coins or fiat currencies. In this case, by default, the currency pairs are useful for information, and you don’t have to do anything with them. That said, you can still utilise them for hedging, especially if you have a relatively big position in one or more in the coins. This way, you can use currency pairs to temporarily reduce your exposure to the coins without having to sell them or exchange them for other coins.

Let’s see an example:

Let’s say you bought 10 ETH coins for $100 each ($1000 in all) and now those coins are worth $350 each ($3500 in all). Now, you think that Ethereum has risen too quickly, so you want to wait for a correction to re-enter. You could convert your ETHs to Dollars or Bitcoins, but that might take time and it could have steep fees.

What you can also do is to take a short position in the ETH/USD or ETH/BTC pair in any of the exchanges you trade to “hedge” your exposure. This is an instant and possibly cheaper solution than a sale, of course, depending on the transaction and margin costs.

Trading with currency pairs or other investment vehicles

This is the point where it might get a bit confusing for beginners, as with a margin account, the currencies or coins you own are not necessarily reflective of the trading or investment positions you hold. And as traditional brokers are broadening the ways of investing in cryptocurrencies, and we will probably soon see crypto-ETFs popping up, this will likely just get more complicated. So if you have a trading account denominated in Bitcoins, you might actually end up being short Bitcoin through pairs. Also, in the future, you will have more and more ways of getting exposure to cryptocurrencies without even having a wallet or as much as one coin.

So, even if you have a trading account denominated in Bitcoin or Ethereum, you might actually end up being short those currencies through pairs. In the future, you will have more and more ways of getting exposure to cryptocurrencies without even having a wallet or as much as one coin, meaning that you will always have to exactly know what positions you have in the different vehicles and what those mean for your portfolio.

The most important thing, again, is that currency trading means “betting” on the relative performance of two currencies not just investing in a currency. When taking on a leveraged position, these bets might be outsized compared to your portfolio, especially given the volatility of the crypto-world, while also coming with huge transaction costs in the form of commissions and fees.

The different performance of the most traded crypto-pairs in 2017

Of course, as is the case with traditional forex trading, the profit potential is very tempting, but beware that entering the world of investment through short-term trading or day-trading often leads to steep losses, as it is one of the most challenging fields of financial markets. On other note, you can actually reduce your risks with cryptocurrency pairs as well, and get exposure only to the relative performance of two coins, and remove the generally huge volatility of coins versus fiat currencies, like Ethereum’s swings against the Dollar on the chart above

As you can see, currency pairs provide fascinating investment opportunities if you take the time to understand their basic properties. Once again, we would like to encourage you to ask your questions and give your personal insights about the topic in the comment section.

Author:
Trader and financial analyst, with 10 years of experience in the field. An expert in technical analysis and risk management, but also an avid practitioner of value investment and passive strategies, with a passion towards anything that is connected to the market.