By Sean Hyman Strange but true…

Many Forex traders – even professional Forex traders – don’t trade exotic currencies.

There are several reasons why. Some traders simply don’t understand the profit potential of trading exotic currencies from smaller emerging market countries.

Some traders like to stick to currencies they know. So if they’ve been tracking the euro or yen for the last 10 years, they’re not willing to switch over to another batch of currencies from smaller, more out-of-the-way countries.

But let me be the first to say…they don’t know what they’re missing. As I’ve written here in FX University in the past, the single most profitable trade of my entire Forex career was an exotic currency trade.

In fact, the truth is if you catch a trend in exotic currencies, these exotic currencies can regularly hand out as much as five times more profits (or 500% more!) than regular major currencies.

Reason: There are key differences between exotic currencies and regular majors that give them much more profit potential.

Just take a look at the charts below. I’ve included a chart of a traditional exotic currency, the South African rand (USD/ZAR), and a chart from the oldest major currency in the world, the British pound (GBP/USD). While the squiggly lines on the chart appear the same, there are several important differences that we need to talk about.

South African Rand Makes Leaps…

…While the British Pound Strolls

The Strange But VERY Profitable Difference

The first thing traders notice about exotics is how many pips these amazing currencies can move on any given day.

The top chart shows that the South African rand has an average daily range (ATR indicator) of 1,000 pips a DAY during a normal trading year. Last year, during the credit crisis, the South African rand was moving over 7,000 pips in a day!

During the same timeframe, the British pound varied from moving 150 pips a day to 550 pips a day at the height of the credit crisis.

So the actual number of pips these currencies move per day is far more in the exotic pairs than the majors…even volatile majors like the British pound.

Note: The reason for so much volatility is exotic currencies traditionally have thinner volumes than the majors. As such, news events move these exotic currencies more than the major currencies.

Also, when you’re watching exotic currencies, you’ll notice that these currencies tend to have a bit more erratic behavior. That’s because traders in exotic currencies tend to dive in and out faster. In other words, Forex traders want the higher yields and pip movements that only exotic currencies can offer. However, if traders sense trouble, they are quick to bailout of their positions.

Exotics Actually Present LESS Risk to Your Account on a Pip-to-Pip Basis

Some currency investors are drawn to exotics because of that very volatility, while others shy way from them for that very reason. However, when it comes to exotics, the payout in dollars in these currencies varies significantly from their pip value.

For instance, when you buy a major currency pair like the euro (EUR/USD) or British pound (GBP/USD), you usually risk about a $1 every time your pair moves a single pip in a mini-account. You also earn about $1 a pip every time it moves in your favor.

However, many exotics only pay out about 12 to 63 cents per pip of movement on average. So how many dollars you’re actually winning or losing per pip is vastly different than a major. Most traders don’t acknowledge that.

Therefore, your actual dollar risk is “toned down” more than you think when you play exotics. Especially considering you’re only risking 10-60% of a pip compared to a major currency pair (in dollar terms).

So if you were trading the South African rand, you would have to trade about eight times the typical number of mini-lots in order to equal 1 mini-lot of the typical British pound (GBP/USD) trade.

In the case of the Turkish lira, I’d have to trade about twice as many lots as I did for the GBP/USD to be about the same risk dollar wise.

False Argument Against Exotics: The Spread Is Too wide! Wrong!

Another huge difference at first glance is the pip spread difference between the major currency pairs and the exotics.

And yes, there is a big difference in pips.

The spreads on exotics may be between 50 – 200 pips vs. majors being 2-5 pips for instance. However, when you convert those “exotic pips” into dollars, you’ll find that the cost is about $24-$31. Yes, that’s more than the majors BUT it’s not nearly as much as it sounds when we were talking about the number of pips that it cost per trade.

Now some argue that they wouldn’t trade an exotic pair due to that cost difference because a major pair would be $2 to $5. However, again, they’re not considering how volatile, and how potentially profitable exotic pairs can be.

Many of these exotic pairs can move 500 to 3,000 pips in a day. So just like you can cover the 2-5-spread cost in a major currency pair that moves 180 to 250 pips in a day, you can do the same thing with an exotic pair. Any currency pair that moves 500 to 3,000 pips in a day can easily erase its 50-200 pip spread cost.

The point being…an exotic pair with a high pip spread is also volatile enough to cover that spread cost and then some. In fact, an exotic currency can quickly cover its cost just as fast as the lower volatile majors cover their spreads.

So exotics have higher volatility, higher spreads, YET the pip cost is lower. That helps lower the dollar amount of the spread.

Another bonus: The daily interest earned on these pairs is generally significantly higher. So if you call the direction right and earn significantly more interest along the way, it does help to compensate for any added risk.

Fundamentals Aside, You Need to Watch Investor Sentiment!

One final difference in exotics over the majors is the ability to get fundamental data on the currency. Oh yeah, you can get it from their central bank’s site. And you can get some info from Bloomberg, etc.

But other than that…it’s sometimes hard to gain all of the fundamental data that you can readily get from a major industrialized country.

However, with that said, the main, big overriding factor with exotics is usually how risky investors are willing to be. When economies are recovering or in a boom, exotic currencies tend to push higher (pushing the USD/ZAR, USD/TRY, etc. downward as the foreign currency rises up against the dollar).

But, when “times are tough” around the world and investors get cautious, the exotics are some of the first ones they run from (which gives a great tradable opportunity too as these pairs shoot up as they run to the dollar).

So in either case, exotics can be a great trade. Indeed, they can be five times more profitable than majors. Right now, may be the best time to trade them…as economies are pulling out of a recession and stock markets are showing signs of recovery again.

Happy Trading!
Sean Hyman, aka Professor FX

P.S. BIG NEWS: Our Exotic FX Alert – that regularly averages as much as 230% winners – is finally open to new traders. Get all the details here.