Understanding How Cross-Currency Pairs Influence Dollar-Based Trades

Market movements in major currency pairs don’t occur in isolation. Cross-currency pairs often play a pivotal role in influencing how major pairs behave, even for traders who focus exclusively on dollar-based trades.

A Scenario to Illustrate the Effect

Imagine a situation where the central bank in the United States announces an interest rate hike. This triggers a surge in demand for the U.S. dollar across the board. As a result:

EUR/USD and GBP/USD drop as the dollar strengthens against the euro and the pound.USD/CHF and USD/JPY rise as the dollar gains value relative to the Swiss franc and Japanese yen.

Suppose you took a short position on EUR/USD, benefiting from its decline. But then you notice a fellow trader who went long on USD/JPY made significantly more profit.

Analyzing the Disparity

Looking at the charts, you observe that USD/JPY surged by 200 pips, breaking a key resistance level and sparking a rally. In contrast, EUR/USD fell by only 100 pips and failed to break through its major support level.

What explains this difference? The answer lies in cross-currency pairs, particularly EUR/JPY.

The Role of Cross-Currency Pairs

When USD/JPY broke through its resistance level, the move prompted traders to sell the yen more aggressively. This yen weakness spilled over into EUR/JPY, causing the euro to gain strength relative to the yen.

As EUR/JPY rallied:

The buying pressure on the euro offset some of the selling pressure in EUR/USD.This acted as a "parachute," slowing down the decline of EUR/USD compared to the sharper rise in USD/JPY.

The Domino Effect

Here’s a breakdown of how the process unfolds:

Breakout in USD/JPY: A surge in USD/JPY triggers stop-loss orders and attracts traders looking to capitalize on the breakout.Impact on EUR/JPY: The yen weakness fuels buying in EUR/JPY, pushing it higher.EUR/USD Reaction: As EUR/JPY strengthens, the upward pressure on the euro tempers the downward movement in EUR/USD.

This explains why EUR/USD didn’t fall as sharply as USD/JPY rose, despite the broad-based strength of the dollar.

Key Takeaway

Even if you trade only major currency pairs, it’s crucial to consider the influence of cross-currency pairs. Movements in crosses can dampen or amplify the effects you observe in major pairs, impacting the profitability of your trades.

By keeping an eye on relevant cross-pairs, you can better anticipate how major pairs might behave and adjust your strategies accordingly.

Understanding How Cross-Currency Pairs Influence Dollar-Based Trades

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