Foreign exchange trading, also known as forex or FX trading, involves exchanging one currency for another. While the major global currencies like the U.S. dollar, euro, British pound and Japanese yen are considered ‘hard’ currencies, some national currencies are viewed as ‘soft’. Understanding what makes a soft currency ‘soft’ and how to effectively trade soft currency pairs can give forex traders a strategic advantage.

What is a Soft Currency?

In foreign exchange markets, the term ‘soft currency’ refers to a national currency that lacks stability and is generally weaker against other major global currencies. A soft currency usually belongs to an economy with high inflation, large trade deficits, smaller foreign currency reserves and uncertain political climates.

Some examples of currently soft currencies include:

  • Argentine Peso (ARS)
  • Turkish Lira (TRY)
  • Indonesian Rupiah (IDR)
  • Indian Rupee (INR)
  • Russian Ruble (RUB)
  • Brazilian Real (BRL)
  • South African Rand (ZAR)

These emerging market currencies lack the stability and trust of reserve currencies like the U.S. dollar and euro. As a result, they tend to gradually depreciate in value over time against harder currencies.

What Makes a Currency Soft?

There are several economic and geopolitical factors that cause a currency to be considered soft:

High Inflation

Countries with persistently high inflation rates tend to have soft currencies. When domestic prices rise faster than foreign prices, the currency loses purchasing power very quickly. This drives down external demand and leads to currency devaluation. For example, Argentina has suffered from hyperinflation in recent years.

Large Current Account Deficits

A current account deficit occurs when a country imports far more goods and services than it exports. This imbalance means high demand for foreign currency to pay for imports, causing the local currency to weaken over time.

Low Foreign Reserves

Central banks use foreign currency reserves to maintain the value of their own currency. When reserves are low, the bank cannot easily intervene to prop up the local currency when its value slides. Insufficient reserves exacerbate currency weakness.

Political Instability

Uncertainty in domestic politics or economic policies can diminish trust in a nation’s currency. Investors become wary of keeping assets denominated in that currency if future volatility and devaluation seem likely.

Speculation

Currency traders and investors themselves can drive down the value of a soft currency based on speculation. If enough major players in forex expect a currency to fall and act accordingly, it becomes a self-fulfilling prophecy.

Risks of Trading Soft Currencies

While softer currencies present certain opportunities, trading them also comes with amplified risks. Here are some key dangers to consider:

  • High Volatility – Soft currencies fluctuate wildly in response to economic and political developments. Sudden daily price swings can stop out positions and make trends unpredictable.
  • Unexpected Government Interventions – Central banks frequently implement capital controls, foreign exchange limits and new regulations to halt slides in soft currencies. Such actions are hard to foresee and can disrupt trades.
  • Likelihood of Long-Term Depreciation – Unless fundamental conditions improve, soft currencies tend to lose value over the long run compared to stronger counterparts.
  • Vulnerability to Market Sentiment – Sentiment and speculative attacks can accelerate selloffs in soft currencies in ways unrelated to economic fundamentals.

Benefits of Trading Soft Currency Pairs

Despite the risks, trading FX pairs with a soft currency component can offer significant trading advantages:

Favorable Exchange Rates

With soft currencies like the Turkish lira, Indonesian rupiah and Indian rupee depreciating over the long term, exchange rates become very favorable. Traders based in countries with harder currencies can capitalize.

Favorable Pips/Pip Values

Depreciating soft currencies mean the pips and relative pip values of such currency pairs move in the trader’s favor. The pip gains translate into bigger profits.

Higher Interest Rates

Central banks often raise interest rates to defend soft currencies. The higher yields provide interest income for traders holding the soft currency. Carry trades take advantage of this.

Greater Volatility

Although higher volatility implies higher risk, for experienced traders it also means more opportunities to profit from price swings. Trading sessions with soft currencies tend to see bigger moves.

Diversification

Soft currency pairs provide diversity and opportunities for gains not as tightly correlated with mainstream FX pairs. This expands hedging options and portfolio balance.

5 Key Strategies for Trading Soft Currencies

Now let’s explore some practical trading strategies to deploy when dealing with soft currency assets:

1. Follow the Long-Term Trend

With soft currencies mostly depreciating against harder counterparts, the overriding trend is down. Use daily or weekly charts to identify the current direction and go with the flow by selling the soft currency against the major one. For example, shorting the Turkish lira against the euro.

2. Trade the Range

Soft currencies sometimes oscillate in multi-week or multi-month ranges before weakening further. Use price action analysis or indicators like Bollinger Bands to spot these ranges. Buy the bottom of the range and sell the top on shorter timeframes.

3. Fade Extreme Spikes

Excessive volatility creates large temporary spikes in soft currencies. Enter counter-trend trades when spikes push price at least 2 standard deviations from the mean, then ride the snapback. Close quickly for 10-30 pip gains.

4. Focus on Reversals

Major news or central bank interventions can abruptly reverse soft currency slides. Use candlestick patterns on hourly or 4-hour charts to spot reversal setups. Enter long on hammer or inverted hammer signals after sell-offs.

5. Watch for Divergence

Price diverging from indicators like MACD or RSI often precedes reversals in soft currencies. If price makes new lows but momentum is waning, get ready to buy. Confirm with candlestick signals.

Scenario Analysis for EUR/TRY Pair

Let’s walk through a real example of trading the euro against the Turkish lira, a classic soft currency pair.

In mid-2021, the lira depreciated heavily versus the euro. Long-brewing economic issues in Turkey accelerated, while lagging tourism due to COVID-19 also hurt the lira.

Daily and weekly charts clearly showed strong downtrends in EUR/TRY, with series of lower highs and lower lows.

Strategy

This trend direction signaled opportunities to short the lira against the euro. We can enter short trades on rallies up to the daily 20 or 50-period moving average after sell-offs. Initial stops above the moving average highs and targets at recent swing lows.

Execution

On August 5, 2021, EUR/TRY spikes up to test the daily 20 SMA around 10.15 after a selloff. This presents an opportunity to go short in line with the downtrend.

We short sell at 10.12 with a stop at 10.18 and initial target at the August 2 swing low of 9.92. The trade hits its target the next day for a gain of 200 pips.

Risk Management

With the lira extremely volatile, position size is kept small at just 5% of capital to limit risk on this short trade. Stop is placed conservatively above the 20 SMA to allow for whipsaws.

Key Takeaways: Trading Soft Forex Currencies

Here are some key lessons for effectively trading FX pairs involving soft currencies:

  • Identify soft currencies prone to long-term depreciation against harder counterparts. Research economic fundamentals.
  • Trade in the direction of the prevailing daily or weekly chart trend by selling rallies in soft currencies.
  • Use suitable stop losses to protect against short-term spikes and whipsaws. Give trades room to breathe.
  • Buy extreme short-term spikes to profit from the inevitable snapback toward the mean price.
  • Watch for candlestick reversal signals or bullish divergence to catch turnarounds after heavy selloffs.
  • Manage position sizing to limit risk exposure to the inherent volatility of soft currencies.

While trading soft currencies requires assuming higher risks, the rewards can also be great. By combining prudent strategies with disciplined analysis of price action, forex traders can take advantage of soft currency opportunities.

This comprehensive guide covers key aspects of trading soft currencies, including common characteristics, risks and benefits, strategic advice, and scenario analysis. The conversational tone and detailed, practical recommendations aim to inform and empower forex traders interested in the soft currency niche.