Introduction

The foreign exchange market offers traders access to a wide variety of currency pairs to trade, from major pairs like EUR/USD to minor and exotic pairs. However, there are some cross currency pairs like EUR/GBP that are not available to trade directly on forex trading platforms. This is where synthetic currency pairs come into play.

A synthetic currency pair, also known as a synthetic cross, is a trading strategy that involves taking positions in two separate currency pairs to mimic the price movement of a cross currency pair that is unavailable for trading. Synthetic pairs allow traders to gain exposure to and profit from the price movements of currency crosses that their brokers do not offer.

In this comprehensive guide, we will cover everything you need to know about synthetic currency pairs and how to trade them profitably.

What Are Synthetic Currency Pairs?

A synthetic cross or synthetic currency pair is created by combining two separate currency pairs to create the effect of a non-existing cross rate. For example, the GBP/USD and EUR/USD currency pairs can be combined to create a synthetic EUR/GBP cross rate.

Synthetic pairs come in handy when a trader wants to trade a currency cross that is not directly available in the forex market. Instead of taking a direct position on the unavailable cross rate, the trader can recreate the cross synthetically using two related pairs.

Let’s break this down further using an example of creating a synthetic EUR/GBP, which most brokers don’t offer directly:

  • EUR/USD gives the EUR/GBP exchange rate from the perspective of pricing Euros in US Dollars.
  • GBP/USD gives the same rate but from the inverse angle of pricing British Pounds in US Dollars.

So by combining a long EUR/USD position with a short GBP/USD position of the same nominal value, a trader can create the same effect of having a direct long EUR/GBP position in terms of profit and loss. The two legs of the synthetic pair will gain and lose together to replicate the non-existing cross rate.

Why Trade Synthetic Currency Pairs?

There are several advantages of using synthetic currency pairs in forex trading:

Gain exposure to more currency pairs

The main benefit of synthetic pairs is that they allow traders access to cross currency pairs that they otherwise couldn’t trade directly with their brokers. Traders who base trading decisions on cross rates can gain that required exposure.

Arbitrage opportunities

Synthetic pairs can sometimes be used to take advantage of arbitrage opportunities between the real and synthetic prices. Traders can execute risk-free trades when the synthetic price and real price diverge enough to exploit.

Hedge existing positions

Traders can use synthetics to hedge risks associated with one leg of the pair without needing to close the position. For example, a long EUR/USD position can be hedged by shorting GBP/USD synthetically.

Spread trading

The price difference between the real cross rate and the synthetic equivalent presents spread trading opportunities. Traders can go long or short the spread if it diverges significantly from the mean.

Diversify trading strategies

Synthetics provide an additional tool to diversify trading strategies for potentially higher and more reliable profits. Traders not restricted to existing currency pairs on platforms.

How to Create Synthetic Currency Pairs

Constructing a synthetic currency pair is a straightforward process that involves just two steps:

Step 1: Identify the Two Currency Pairs

The first step is to identify the two component currency pairs to combine. The pairs should have one currency in common, usually the US dollar.

For example, to create a synthetic EUR/GBP cross, you need EUR/USD and GBP/USD, since they both have USD as the counter currency.

Step 2: Take Opposing Positions

Once you identify the relevant currency pairs, you take opposing positions of the same size in each pair:

  • To create a long synthetic cross (e.g. long EUR/GBP), go long the base currency pair (EUR/USD) and short the terms currency pair (GBP/USD).
  • To create a short synthetic cross (e.g. short EUR/GBP), short the base currency pair (EUR/USD) and long the terms currency pair (GBP/USD).

The ratios don’t need to be exactly 1:1, but they should equate nominally for the synthetic cross to perform as expected.

Let’s look at an example to make this clearer:

  • You want to create a synthetic long EUR/GBP position.
  • You go long 0.5 lots EUR/USD
  • You go short 0.5 lots GBP/USD
  • The two positions combine to create the effect of being long EUR/GBP synthetically.

By following these two simple steps, you can create any synthetic currency cross needed for your forex trading strategy.

How Do Synthetic Pairs Work?

Synthetic pairs work on the principle of spreads between currency pairs and their cross rates. Here is a step-by-step breakdown:

  1. Decide on the synthetic cross pair you want: for this example we’ll use EUR/GBP.
  2. Identify the two component currency pairs. For EUR/GBP that would be EUR/USD and GBP/USD.
  3. Monitor the exchange rate spreads between EUR/USD, GBP/USD and the EUR/GBP cross rates.
  4. When the synthetic price derived from EUR/USD and GBP/USD diverges significantly from the actual EUR/GBP price, an opportunity arises.
  5. To profit, create a synthetic EUR/GBP position by going long EUR/USD and short GBP/USD in equal lots.
  6. When the price spreads converge, unwind the positions to realize your profit.

So in summary, synthetic pairs work by allowing you to gain exposure to a cross rate derived from the prices of its components vs the USD. Profitable opportunities arise when the synthetic and real prices diverge.

Reading Synthetic Cross Rates

Since you are combining two separate forex pairs, reading and quoting synthetic pair prices requires some knowledge:

  • The synthetic pair is quoted just like a real cross currency pair, with the base currency on the left.
  • However, the rate has to be derived from the two components on a currency calculator or spreadsheet.
  • The synthetic price is calculated by dividing the base pair rate by the terms pair rate.

For example, if EUR/USD is trading at 1.1300 and GBP/USD is at 1.3500, then the synthetic EUR/GBP rate is:

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               1.1300 / 1.3500 = 0.8370

So the synthetic EUR/GBP cross rate would be quoted as 0.8370 in our example. This represents how many GBP a single EUR can buy.

Knowing how to calculate the synthetic prices accurately by hand is vital for successfully trading synthetic pairs.

The Risks of Synthetic Currency Pairs

While synthetic pairs offer opportunities, they also come with some unique risks to keep in mind:

  • Spread risk – The potential profit depends on the spread between real and synthetic prices. If the prices converge too quickly, the spread trade may lose money.
  • Double leverage risk – Traders must use leverage on both legs of the synthetic pair, amplifying risks. Margin requirements are also higher.
  • Slippage risk – Entering or exiting both positions simultaneously to create or unwind the synthetic may be difficult due to lag and slippage.
  • Conversion fees – Traders may incur higher transaction costs from the bid-ask spread and fees in both pairs.
  • Interest rate differential – Differences in interest rates between the currency pairs introduces another variable.

Due to these risks, synthetics may not be suitable for all traders. Proper risk management is essential when utilizing synthetic pairs in trading strategies.

Tips for Trading Synthetic Currency Pairs

Here are some tips to trade synthetic currency crosses profitably and manage risks:

  • Look for pairs with a high correlation for efficiency. GBP/USD and EUR/USD usually have a strong negative correlation for creating synthetics with EUR or GBP.
  • Monitor real and synthetic prices closely using charts and pay attention to widening spreads. A spread tracker tool can help.
  • Calculate your risk-reward ratio and expected profit target from the spread to determine position sizing.
  • Use stop loss orders on both synthetic legs to control downside risk if spreads move against you.
  • Keep position sizes small – no more than 5% of your account per trade. Synthetics carry higher risk.
  • Manage leverage carefully and avoid over-leveraging the synthetic pair.
  • Be patient and wait for low-risk, high-probability trading opportunities to arise.
  • Unwind positions as soon as upside profit target is reached before spreads reconverge.

By following sound risk management practices, traders can effectively use synthetic pairs while limiting the risks.

While any cross currency pair can be synthetically created, here are some popular combinations traders look to access:

  • EUR/GBP – Created from EUR/USD and GBP/USD. Allows trading the EUR/GBP cross.
  • EUR/CAD – Created from EUR/USD and USD/CAD. Provides exposure to fluctuations between Euro and Canadian Dollar.
  • GBP/JPY – Created from GBP/USD and USD/JPY. Useful for trading the British Pound vs the Japanese Yen.
  • AUD/NZD – Created from AUD/USD and NZD/USD. Allows trading between the Australian and New Zealand Dollars.
  • USD/SEK – Created from EUR/SEK and EUR/USD. Provides access to swings between the US Dollar and Swedish Krona.

These are just a few ideas. Traders can synthetically create any currency cross needed to implement their trading strategies.

Synthetic vs Futures and Forwards for Currency Exposure

Beyond just using spot synthetic currency pairs, there are other financial instruments that can provide exposure to cross currency rates, namely futures and forwards. Here is a look at the key differences:

Futures

  • Exchange traded derivatives contracts with standard contract specifications.
  • Requires much lower upfront capital than synthetics.
  • Offers high leverage up to 20:1 in some cases.
  • Limited contract varieties available only for major currencies.
  • Futures contracts have fixed expiration dates.
  • More susceptible to gapping and higher volatility.

Forwards

  • Customizable private agreements between counterparties.
  • Provides exact cross rate exposure needed.
  • Forward rate speculation and hedging capabilities.
  • Rate locking provides certainty.
  • Credit risk if dealing with unregulated dealers.
  • Contract sizes can be prohibitively large for small traders.

Synthetic Spot Pairs

  • Made up of actual spot currency pairs using margin accounts.
  • Provides real-time customizable exposure without expirations.
  • Complex to price and manage spread trade opportunities.
  • Requires maintaining optimal leverage levels on both legs.
  • Unlimited flexibility in terms of cross pairs.

Each instrument has pros and cons for gaining currency exposure. Synthetics provide a middle ground balancing customization, costs, and trading simplicity.

Common Synthetic Pair Strategies

Here are some of the most common trading strategies applied utilizing synthetic currency pairs:

Spread Trading

Taking advantage of diverging spreads between real and synthetic prices, often aided by a spread tracker tool. Requires patience and precision in execution.

Hedging

Using synthetic pairs to hedge risks associated with one leg of the pair without closing positions. Useful for short term protection.

Arbitrage

Profiting from arbitrage opportunities when real and synthetic prices materially diverge. Risk-free profits, but rare and fast-closing.

Directional Trading

Taking directional views on cross currency rates using synthetics pairs. For example, those trading a bullish EUR/GBP outlook.

Correlation Trading

Looking for extreme correlations or divergences between pairs for mean reversion potential. Relies on statistical relationships.

basket Trading

Combining several currency pairs including synthetics into a correlated basket offering diversity. Pairs trading is an example.

The beauty of synthetic pairs is the flexibility they provide traders to implement creative strategies.

The Bottom Line – Key Takeaways

Synthetic currency pairs provide traders with additional tools to broaden trading opportunities and hedge risks. Here are the key takeaways:

  • Synthetic pairs allow gaining exposure to cross currency rates not available to trade directly.
  • They are created by combining two separate spot forex pairs in opposing directions.
  • Traders can exploit pricing spreads, diversify strategies and hedge existing positions.
  • However, synthetics come with leverage, slippage and correlation risks to manage.
  • Following wise risk management practices is crucial when trading synthetic pairs.
  • With the proper knowledge, synthetic crosses can be a useful addition to any forex trader’s arsenal.

Synthetic currency pairs offer a way for traders to access a wider universe of forex opportunities. By understanding how to create, manage and profit from synthetic pairs, traders can further enhance their strategies.

Conclusion

Synthetic currency pairs represent an advanced forex trading technique that can provide seasoned traders with additional flexibility and risk management capabilities. While not without risks, those who use proper precautions can unlock new opportunities and hedge existing exposures by combining major pairs in creative ways.

As global currency markets continue evolving, synthetics provide a valuable tool. Traders who take the time to learn this method can find themselves uniquely positioned to profit in new ways from ever-changing forex correlations and spreads. But prudent risk control remains essential.

By mastering the intricacies covered in this guide, both novice and experienced forex traders can gain the confidence to deploy synthetic pairs as part of their overall trading plan. The ability to profitably trade even non-existent cross rates can provide that extra edge.