Often I read posts by those who claim that it makes no sense to trade a correlated pair as it is simply a "synthetic cross", so why not simply trade that cross? This is a good question and a good strategy (sometimes).
There are great reasons to simply trade the cross directionally.
IF both major pairs give a good, strong trend signal in the appropriate directions, trading the cross is very profitable as it can produce far more pips. For example, at recent market prices for the GBPUSD/USDJPY a 100 pip move in each in the same direction would be a 319 pip move in the GBPJPY cross. If I wanted 50 pips, I would rather take it out of a 319 pip move where there is a lot of extra room. I explain the math in post 319
http://www.forex-tsd.com/138503-post315.html. This can be a very good trade and Bill Young at GoFXPro uses it for his clients using some of my indicators.
The risk is that the cross is prone to extreme whipsaws. In that example, if the majors each retraced 25 pips, the cross would retrace 75 pips at the same time. Be prepared to use larger stops, or expect sudden losses, even when the correct overall direction was known.
Trading the correlated pair for divergence has its own strengths. Let me tell you about a bad trade I made last month in my real money accounts. I've been avoiding the JPY pairs knowing the fall was coming, so I've traded the GBPUSD/EURUSD in opposite directions for quick profits every day or two. On August 6th at 6AM London time I had a signal for a nice little divergence long GBPUSD/short EURUSD. I placed the trade and went to bed leaving my C4 robot to handle the exit.
Two hours later the news broke about hoof and mouth disease in England among the cows.
Wham! Suddenly the GBPUSD side of my trade was down 100+ pips in a negative deconvergence. Over the next couple days it was down almost 300 pips. Stupid cows...
If I was in a directional trade for the GBPUSD I would have taken a loss at some point in the last three weeks as the GBPUSD fell 700-ish pips from my entry at 2.0436. But, as I was in a correlated trade, my largest drawdown was around 300 pips, which I would consider way too much in a directional trade but not in this kind of correlated trade. Bill Young would laugh at me and would have been out of the trade and into something better while I am still sitting around bonding with the stupid cows...
I don't need the GBPUSD to get back above 2.0436 to profit.
This is the huge benefit of correlated trades. I just need it to get back up above its relative entry point with the EURUSD even if it NEVER gets back above my entry price. So, I have been sitting in this trade for three weeks earning interest and waiting for the pairs to reconverge and averaging in a bit to help that along. Stupid cows...
The pairs have come back very close to each other and I only have a 50 pip gap at this time. That should close in the next couple weeks, perhaps on NFP Friday.
So, even though I was hammered by unexpected news about stupid British cows (anyone getting the impression that I'm holding a grudge against the cows?) I didn't need to take a loss. It will be a profit - though a slower one because I was able to stay in the trade, and the drawdown was much less due to the correlated pair dampening the market fluctuations, and because I can still exit at a profit even at a lower price than my long entry point, and finally I've been earning a small bit of swap for sitting in this trade.
Trade carefully,
Bill
