A synthetic currency pair allows you to reduce the spread costs of trading. If your broker charges an arm and a leg on on the cross currencies and you trade more than a few micro lots, you can potentially save a few pips by creating the cross currency on your own rather than paying for exorbitant spreads. This is especially true if your forex broker falsely classifies itself as an MT4 forex ECN. Many of these types offer very low spreads on the majors, but retain the high mark ups commonly associated with cross currencies.
To determine if this makes sense for your situation, you need to calculate the pip values of the spread of the offered cross currency and the spread cost of your synthetic currency pair.
Say, for example, that you trade GBP/JPY. Your broker charges a hefty, though common, spread of 7 pips. Trading one standard lot presently works out to:
$100,000 = JPY 7,500,000
A 1 pip change is worth JPY 1,000, which is worth $13.33 per pip. The 7 pip spread costs $13.33 * 7 = $93 per trade. Ouch.
How to make a synthetic currency pair
Now, we take the more cost effective approach. You want to choose two currency pairs that cancel each other out, yet offer the lowest trading cost possible. The obvious candidates are USD/JPY and GPB/USD for the synthetic cross.
Cancelling out the pairs is pretty straight forward. The goal consists of multiplying something expensive with something cheaper to save on costs.
|Expensive cross currency||Replacement currency|
Swap the terms on the bottom. Doing so changes nothing mathematically, but does everything to clarify the siutation to any forex trader.
We must evaluate the cost of the synthetic candidates now that we know which pairs to consider trading. If the GBPUSD costs 2.5 pips to trade and the USDJPY costs 2 pips, the total cost is
$25 in spread on 1 standard lot of GBPUSD
$26.66 in spread on 1 standard lot of USDJPY. We must increase the lot size to 1.55 lots, however, to ensure that we sell as much yen as we bought in pounds. The final cost for the USJPY equals $41.32.
Trading a synthetic pair only costs $41.32 + 25 = $66.32. Trading directly from the broker costs $93. Although it takes a lot of extra effort, I highly recommend this approach if you’re not trying to scalp or quickly enter positions.
Overpaying for a trade by nearly 30% is wholly unjustified. You put so much effort into developing a trading strategy. Earning profits in forex is hard enough as it is. Stop overpaying for your trades; the broker is taking advantage of either your laziness or ignorance when you do.