Most trading literature leans towards a negative perception about forex exotics. It is true that a majority of these markets are expensive to trade due to being less popular markets and may exhibit erratic price movements.
However, upon closer inspection, for long-term traders, trading a handful of these markets can be worthwhile depending on several factors.
What are exotic pairs in forex?
Exotics are the third and final group of forex pairs (after major and minor/crosses) from the so-called developing countries. Popular currencies in this category include the Chinese yuan (CNH), South African rand (ZAR), Singaporean dollar (SGD), Turkish lira (TRY), and so on.
Exotics are not a common feature in everyday global financial transactions; hence, many brokers charge higher-than-usual spreads due to their illiquidity. The cost, liquidity, and somewhat unpredictable price movements are typically the primary reasons many traders cite exotic markets as a no-go area.
While there is truth to this sentiment, not all exotics exhibit this behavior if we consider how the industry and economies have evolved.
Not all exotics have high spreads and low liquidity
As established, one of the arguments for traders staying away from exotics is these markets have remarkably high spreads and are thinly-traded, the latter of which can create erratic market movements, especially during quieter periods.
While all of these considerations have merit and are indeed true for a vast number of exotics, there are a handful of exceptions worth exploring. What we should consider is there are many countries like China (CNH), Mexico (MXN), Russia (RUB), and Singapore (SGD) classed in exotic pairs that have very developed economies with high yearly nominal GDPs.
This tells us that there is substantial interest in these currencies globally and sizable daily international trade between these countries. During a normal day, the average spread for GBP/SGD and EUR/SGD can hover around four pips, a figure which isn’t far off from many minor pairs (and, in fact, is lower than some of them in several instances).
Exotics can offer unique trading opportunities not correlated with other forex markets
There are two arguments here as many major and minor pairs move in line with some exotic markets. For example, in several cases, there is a negative correlation between EUR/USD and USD/CNH as both weigh against the US dollar.
So, effectively, a short position on EUR/USD is typically the same as a long position on USD/CNH. Traders need to be careful not to open two opposite orders on markets that are naturally negatively correlated.
The second argument is some exotics do move independently of the US dollar and other more established pairs, which is where the opportunity lies. Correlations do not always remain constant as some currencies can be overwhelmingly stronger than others in certain market conditions.
Long-term traders can sometimes benefit from higher positive swaps when carry trading
The other gain with exotics is they tend to offer slightly high swaps compared to major and minor pairs. This is because of the interest rate differentials. So-called developing countries offer attractive rates (higher than nations in major and minor pairs) to foreign investors to encourage them to invest.
For example, the current interest rates (at the time of writing) for Mexico and the United States are 4% and 0.25%, respectively, resulting in a 3.75% interest rate differential.
Brokers will tend to use their own calculations to factor commission, though if you opened a long position on USD/MXN, you would receive overnight interest for every day you held the trader (one needs to shop around for the best swap rates since they vary).
Carry trading is one strategy position traders with large trading capital use to earn positive swaps. We cannot, however, ignore the opposing side as those trading exotics may, unfortunately, expose themselves to negative interest for every day they hold their orders.
Exotics aren’t for every trader, though
Though there are some ‘hidden’ advantages of exotics, not every trader should consider them as many indeed are expensive to trade. If we couple this to realize that a few can move unpredictably, high-frequency traders cannot benefit from these market conditions.
Long-term traders, namely swing and position traders, should undoubtedly explore exotics to broaden their trading opportunities.
Because of their low trade frequency, limiting to only 28 pairs restricts the number of trade set-ups drastically. Another advantage is even if they may choose a pair with vast spreads, using a bigger risk to reward offsets the cost.
For example, if a swing trader had the desired reward of 300 pips on an exotic pair and the spread was 40, we can see that the potential reward of 260 pips (300 – 40) more than covers the initial cost. In contrast, a day trader with significantly smaller targets will see that the spread is more considerable, eating into any profits they may have made.
So, which exotics are ‘worth the squeeze’?
Picking a handful of good exotic pairs may seem tricky as there are roughly 180 individual currencies globally (meaning there could be as many as a staggering 16,110 different pair combinations).
Fortunately, this article will provide only a small and careful selection of exotics that should form part of a swing or position trader’s watchlist. Some pairs traders may choose to exclude due to the spreads depending on their preferred broker or if they don’t offer a favorable risk-to-reward ratio.
Still, most are generally reasonable across the board. Those trading exotics should consider using a zero spread account that offers reduced and fixed spreads on all pairs (only charging a set commission per trade):
- USD/CNH, USD/MXN, USD/ZAR (South African rand), EUR/ZAR, GBP/ZAR (on these pairs, spreads may be too high with some brokers)
- USD/HKD (Hong Kong dollar)
- USD/THB (Thai baht)
Many exotics pairs in forex naturally come with high trading costs and thin liquidity, though traders can still find the exceptions. Scalpers and day traders should generally stay away from these markets as their trade frequency remains high even with select-few instruments.
Swing and position traders must seriously consider some exotic markets to broaden their trading opportunities (after considering a few critical factors outlined in this article), especially as their trade frequency is drastically lower.