Forex range traders often mistake short-term consolidations for ranges. When they go to make a range trade, they discover that the consolidation was not a long-term range, but rather a short-term consolidation which technically appeared to be a range. Ranges occur all the time, and once a range trader can visually see the range, they often assume it will continue. This often results in frustration and losing trades. However, there is a way to isolate currency pairs, which are more likely to stay range bound and are thus more likely to produce profitable trades from a ranging strategy. By actually avoiding currency pairs involving the U.S. dollar (USD) and looking at central bank interest rates for different countries (currencies), an investor can identify these pairs.

The U.S. Dollar Is a Trending Currency
Since many of the global transactions take place in U.S. dollars, currency pairs involving the dollar are exposed to a trending bias, as opposed to a range-bound bias. While ranges do occur in pairs containing the U.S. dollar, trading these pairs with a ranging strategy over the long term is not as efficient as trading pairs that do not contain the U.S. dollar. If you look at major currency pairs involving the U.S. dollar through 2009, you will see that almost all of these pairs had defined trends. These pairs include the EUR/USD, USD/JPY, USD/CHF, USD/CAD and AUD/USD. These pairs did not move in straight lines in one direction, but it is obvious that any ranges that occurred did not last for long periods of time. Unfortunately, the non-U.S. dollar rule is not 100% accurate, as the GBP/USD did hold relatively well within a range through the last six months of 2009. (For a primer on currency trading, refer to our comprehensive Forex Tutorial.)

But let's look at the most popular currency pair, the EUR/USD. Many traders will trade this pair with any strategy simply because it does the most volume, but it is not the best pair for range trading as can be seen in Figure 1.

Figure 1: EUR/USD Daily Chart
Source: Forexyard

In context, if we look at cross-currency pairs we see more of a propensity to stay within a range. Some ranges are very volatile, while others are more controlled. If we look at 2009 for pairs such as the EUR/JPY, GBP/JPY, GBP/CHF, AUD/NZD, we see more ranging environments. The EUR/CHF (Figure 2) is a great example: while it did experience volatility along with other currency pairs toward the end of 2008 in the financial crisis, it stabilized and held within a 450 pip range for the last eight months of 2009.

Figure 2: EUR/CHF Daily Chart
Source: Forexyard

An overall trending bias in pairs containing the U.S. dollar weakens the probability for profitable range-bound trades on all times frames. While a pair that generally does not trend strongly increases the probability of ranging strategies being successful on all times frames.

Of course, this is not 100% accurate. Some pairs containing the U.S. dollar will be range bound for long periods of time, and a cross-currency pair may also trend for a long period of time. Therefore, we need to filter through which cross-currency pairs are best for range trading. Looking at long-term charts is one way to do this; another is to look at interest rate differentials.

Interest Rate Differentials Affect Volatility
In range trading, there are very volatile pairs that do not trend but that have movements that are erratic and disproportional to previous moves. Then there are pairs that move more rhythmically. The interest rate differential between two countries (currencies) can play a large role in determining these movements. In December 2009, the Reserve Bank of Australia had interest rates at 3.75%, while the Bank of Japan had interest rates at 0.10%, a 3.65% interest rate differential. The AUD/JPY had a average (14 week) true range of 338 pips. If we compare Australia (AUD) to New Zealand (NZD), which had interest rates at 2.5%, only a 1% differential, the average true range (14 weeks) for the AUD/NZD was 230 pips in December 2009.

We can also look at other examples, such as the GBP/JPY, which as of December 2009 had an average weekly (14) true range of 560 pips. The interest rate differential of these currencies is 0.40% (GBP=0.50% and JPY=0.10%). There are other factors that affect volatility, but interest rate differential among currencies pairs is definitely one to watch.

Don't just look at interest rate differentials at one point in time, but rather the relationship over time. While the GBP/JPY interest differential was only 0.40% in December 2009, back in 2007 the differential was 4.50% or higher. Therefore, historically the differential indicates this is a volatile pair.

Picking the Pairs to Range Trade
Ultimately, traders will need to decide for themselves what type of pairs they will range trade. Typically, pairs that do not contain the U.S. dollar are more suitable for range trading. Pairs that have a historically low interest rate differentials are also suitable for range trading.

Long-term charts will give us a good idea of the countries' relationship over time. When we consider an example noted above, the EUR/CHF, it is logical to assume, when we consider how these countries are interlinked, that the pair will not move drastically except in extreme circumstances. It is not likely the Eurozone would suffer disaster without it affecting the CHF or vice-versa. The U.S. and Australia are not as directly linked, and may be exposed to different geopolitical events, thus creating trends as the countries emerge and pull out of phases of the economic cycle at different times.

Just because certain pairs have the prerequisites for a good range trade candidate, doesn't mean that the pair will trade within a range all the time. Proper risk management and solid trading strategy must be implemented. By isolating pairs that satisfy our prerequisites, we stand a greater chance of profiting from our range trading methodology because we are making trades in currency pairs that actually complement the strategy. (Learn about some proper ways to manage risk in Risk Management Techniques For Active Traders.)

The Bottom Line
Successful range trading in the forex market involves more than just visually seeing a range. We can increase our chances of profitability by isolating pairs that do not have a tendency to trend; namely, by excluding pairs that include the U.S. dollar. From the cross-currency pairs, we can then look at long-term charts to see if they have trending bias, and then filter this by looking at the relationship of their interest rate differentials. High interest differentials generally mean increased volatility. Cross-currency countries that are highly interlinked will likely decrease volatility and make the currencies more likely to range. We still need to have a proper range-trading strategy, but by putting the pairs we range trade through our prerequisite screen we stand a better chance of making more profitable range trades.

For further reading, take a look at our Forex Walkthrough.

Related Articles
  1. Personal Finance

    5 Places Where Your Travel Dollar Goes Furthest

    The dollar is pretty strong right now, but where is it strongest? Canada? South Africa? Europe? Here are five places to travel to right now on a budget.
  2. Investing

    3 Things About International Investing and Currency

    As world monetary policy continues to diverge rocking bottom on interest rates while the Fed raises them, expect currencies to continue their bumpy ride.
  3. Forex Education

    Four Currencies Under the Spotlight in 2016

    With currencies having become the “tail that wags the dog,” in terms of their impact on the global economy, these four currencies will be under the spotlight in 2016.
  4. Chart Advisor

    Defined Ranges In Soft Commodities Present Opportunities

    Based on the defined ranges shown on the charts of several soft commodities, now could be the time to watch this group for a reversal.
  5. Investing

    Which Countries Will Drive Global Growth in 2016?

    Given the volatility that has already shaken the global economy, the world's largest economies will be leaned on to stimulate growth in 2016
  6. Stock Analysis

    3 Predictions for U.S. Stocks in 2016

    Read about predictions for the stock market in 2016. See how the energy sector and the biotech sector may be under pressure in the new year.
  7. Investing

    2 Opportunities Amid Today’s Market Volatility

    As you prepare your portfolio for the market volatility ahead this year, here are a few investing ideas to consider.
  8. Term

    Why Countries Keep Reserve Currency

    Central banks and financial institutions hold large amounts of foreign money as their reserve currency.
  9. Mutual Funds & ETFs

    3 ETF Strategies for Growth in Europe for 2016 (FXEU, DFE)

    Learn about the outlook for European economies and how European equities could be poised for a more prosperous 2016 than U.S. equities.
  10. Forex Strategies

    How To Build A Forex Trading Model

    The forex market is volatile, but a forex trading model with clear, step-by-step rules based on a sound strategy can help decrease losing trades.
  1. What is arbitrage?

    Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. ... Read Full Answer >>
  2. How is the value of a pip determined?

    A pip in foreign exchange trading is a measure of a price movement in a currency pair. "Pip" is an acronym for price interest ... Read Full Answer >>
  3. What happens to the US dollar during a trade deficit?

    During a trade deficit, the U.S. dollar generally weakens. Of course, there are numerous inputs that determine currency movements ... Read Full Answer >>
  4. How do I Implement a Forex Strategy when spotting a Sanku (Three Gaps) Pattern?

    A forex trading strategy can easily be implemented to profit from a market reversal signal that comes from the sanku, or ... Read Full Answer >>
  5. What's a good forex strategy to use when spotting a Wedge-shaped Pattern?

    Use wedge-shaped patterns to identify bullish or bearish price action when trading currencies in the foreign exchange (forex) ... Read Full Answer >>
  6. How do I use Time Segmented Volume (TSV) for creating a forex trading strategy?

    You could use time segmented volume (TSV) to build a forex trading strategy, which allows you to compare volume data to determine ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center