Trading the pound is not for the faint of heart. The British currency is traditionally among the most volatile and erratic currencies because of its lower liquidity available and larger point value. Prior to the introduction of the Euro in 1999, only the “Commonwealth” currencies (GBP, AUD, and NZD) had values denominated in U.S. dollars.

Historically, this meant that movements in the pound were among the most risky and expensive, which restrained market interest and liquidity.

For example, option volatilities in the pound tend to run about 10 to 20 percent higher than comparable EUR/USD or USD/JPY volatilities. This is most evident in the pound’s wider spot spreads, as well as its tendency to move in multiple- point jumps — unlike the EUR/USD, which tends to move pip by pip. This suggests traders are better off paying offers or hitting bids to enter the market than waiting for the market to “back and fill.”

Because of the lower liquidity and higher volatility, the pound tends to act as a leader in major U.S. dollar moves, frequently reaching or breaching coincidental technical levels before EUR/USD does. As a result, even traders who are not actively trading the pound still need to monitor its behavior and technical levels for clues about what the EUR/USD rate might do.

For instance, if negative U.S. news sends the dollar lower and the pound and Euro higher, the pound is likely to test identical resistance levels (say, recent daily highs) before the Euro, because the depth of the Euro market will slow its advance.

If the pound breaches those recent highs and follows through, it is a strong signal the Euro will also breach its recent highs and experience follow-through buying. By the same token, if the pound stalls at those recent highs, it is also a likely signal the Euro will fail in its up move.

In a highly directional market, the pound will tend to display extreme one-way behavior, rarely pulling back more than a few pips, while EUR/USD will offer greater corrective opportunities to enter. This suggests traders who are caught on the wrong side of a move need to react more aggressively and not hold out hope for a pullback, while those who are with the move can stay in longer with a trailing stop.

When it comes to technical levels in relatively calm markets, the pound frequently exhibits false breaks, as stop loss orders placed near technical levels make for tempting targets for market players. It is not uncommon for the pound to trade 15 to 20 points through a technical level, and then reverse after associated stop-buying has run its course. This suggests traders need to anticipate potential false breaks and adjust their position size and order level accordingly.

Following the London close, liquidity in the pound falls precipitously, creating the risk for unexpected, position related moves in North American afternoon trading.