If you ask a room full of currency traders which pairs they trade, the vast majority will be quick to respond and tell you that they prefer certain currency pairs over others. Despite the fact that this is very common practice, I find it to be fundamentally wrong. Three years ago I began looking into the relative strengths of individual currencies, as I often found my limit orders getting filled and then the position getting stopped out very shortly after. I would ask myself over and over again: why did this picture perfect technical setup not work? I was obviously missing something very fundamental, which led me to the study of currency strength analysis. In this article, I will discuss the common pitfalls of trading currency pairs instead of currencies, and propose an alternative.
Trading currencies is probably one of the most interesting and difficult endeavours I have ever encountered, as there are so many ways it can be done. You just have to find something that works and do it over and over again. Getting good at trading is difficult and requires an almost unimaginable amount of patience and persistence – and compared to dissecting the worlds most complex computer viruses, which I did prior to becoming a trader, I find that the challenge of trading currencies dwarfs deciphering polymorphic assembler code by far. Well if it’s that difficult then how can it be done, is there a secret? I think that anyone who has figured out how to trade profitably does have a secret, and I think that all the profitable traders do share a secret, a common theme. What is the common theme you ask? Momentum.
Momentum (Google – define:momentum)
- The quantity of motion of a moving body, measured as a product of its mass and velocity.
- The impetus gained by a moving object.
The quantity of motion of a moving body, the body being a currency, is measured in the degree at which a given currency is being bought or sold. The more and faster the buying or selling, the greater the momentum. This is key. So how is momentum, be it buying or selling momentum, identified in currency pairs? Before we continue on the topic of momentum, we must first discuss the notion of trading currencies in contrast to trading currency pairs.
Trading Currency Pairs
If you trade currency pairs and base your trading decisions exclusively on what you see in a given currency pair’s price chart, you’re only seeing a fraction of the big picture. If on the other hand, you trade stocks and base your trading decisions on what you see in the stock’s price chart, you’re seeing the big picture. A currency pair chart will show you only what the two currencies are doing, relative to one another, it will not show you what the two currencies are doing in their entirety. So if the EURUSD currency pair is going up, does this mean that the Euro is strong and the Dollar is weak? Not necessarily, it means that the Euro is strong, relative to the Dollar.
Let us consider the relative strength of the Euro (EUR) relative to the Dollar (USD). How would the strength of the two currencies compare in a sideways market? When a currency pair such as the EURUSD is moving sideways, the relative strength of the two currencies can be any of the following, in varying degrees:
- Strong EUR and USD
- Weak EUR and USD
- Neutral EUR and USD
In other words, the strength of the two currencies is more or less equal, which results in a balance and thus a sideways market. For a currency pair to be moving higher or lower, the relative currency strength of the two currencies must be diverging, such that:
- EUR strength > USD strength OR
- EUR strength < USD strength
In other words, EUR strength must not be equal to USD strength or:
- EUR strength != (is not equal to) USD strength
How then can one identify the relative strength of one currency in relation to another? This is when currency strength analysis comes into play. In order to identify the strength of the two currencies in a pair, one needs to assess how the two currencies are performing relative to all other currencies. For the sake of simplicity, if we wish to identify the strength of the two currencies in a pair, we must identify the strength of the two in relation to currencies that comprise the majority of trading volume for a given currency. If we consider the eight most traded currencies only, when performing our currency strength analysis, we must include the following:
So if we want to identify the relative strength of the eight most traded currencies, this would require an analysis of all possible crosses of the above currencies, which results in the following 28 currency pairs:
Back to our EURUSD example, in order to identify the relative currency strength of the EUR and the USD, we would need to assess the strength of all currency pairs in which the two currencies are a part, which for the EUR would be:
And for the USD:
The analysis will result in a value or an index, which will vary depending on how the calculation is performed, but the result will enable us to answer the question:
Which currency is stronger, the EUR or the USD?
Let us assume that our analysis tells us that the relative currency strength of the EUR is greater than the USD, now, buying the EUR and selling the USD, or buying the EURUSD, would make much more sense, as we know that the EUR is strong and the USD the weak, relative to the seven other currencies. We now have a good reason to buy the EURUSD currency pair, a decision which was made based on a currency strength analysis and not merely on the notion that we just like to trade this particular currency pair.
So summing up this section, looking at the price chart of a currency pair will tell you little about the relative currency strength of the two currencies, in relation to the big picture. Only when you’ve performed an analysis of all currency pairs for a given currency will you know how strong, weak or neutral it really is, and whether the pair should be bought, sold or left alone.
As previously discussed, the strength of individual currencies will help you assess which currencies should be traded and which currencies should be left alone, but how is momentum identified in a currency or currency pair? If we revert our attention to the definition of momentum:
The quantity of motion of a moving body, measured as a product of its mass and velocity.
The product of a currency’s mass can be the index value which is the result of our analysis, and the velocity is the rate of increase – is the relative currency strength for a given currency increasing aggressively or only slightly? These are the questions our analysis needs to answer for us – and when they have been answered, we need to identify a strong currency that is getting stronger, a weak currency that is getting weaker and trade them against each other.
Right, how about some graphical examples please? OK.
Ideally, we need to see the results of our relative strength analysis graphically and in realtime, so that we are able to see bursts of momentum early enough for us to take advantage of them. In the following example, below the price chart, you can see two additional indicator windows. The top indicator window displays currency strength now compared to currency strength 60 minutes or one hour ago, and the bottom indicator window displays currency strength now compared to currency strength 240 minutes or four hours ago. We can see how the relative currency of the EUR compares to the AUD over the past four hours. It is clear that the EUR is selling off and the AUD is rallying, and continuing to do so. At the beginning of the grey box, which is a simple box that is drawn at the open of the active session at two 10 pip intervals (for which I will not discuss here), we can see the currency strength of these two currencies beginning to diverge; the AUD (orange) is strong and getting stronger and the EUR (blue) is weak and getting weaker, which makes for a beautiful trade.
Here we have another example, this time of the NZDCHF. Again, you can clearly see CHF (lime green) strength increasing and NZD (brown) strength weakening, which again is visible in the sudden burst of momentum as the pair sells off.
In this example of the NZDUSD, we have the bottom indicator showing currency strength now compared to currency strength eight minutes ago. We can see that the bottom indicator show early signs of dollar (green) buying but no real change on the NZD (brown). Shortly after we see the two currencies diverging nicely resulting in the almost 40 pip move lower.
Here is another example of an aggressive sell off on the NZDJPY:
As we have seen in this article, currency strength analysis is very useful when deciding which currency pairs to trade. Simply looking at a currency pair chart and assuming that you’re seeing all you need to see in order to trade the two currencies is a very daring assumption, as only a tiny portion of the information required in order to make trading decisions is represented in one currency pair chart. Performing a currency strength analysis on the other hand, really puts the odds in your favour, as you then have a much clearer understanding of what is rallying and what is selling off, across the board, and should always form the basis of any currency trading methodology.