While randomly selecting a currency pair to trade is the recipe most follow when trading currencies, one key ingredient is missing. In this article I will discuss the concept of currency strength and I’ll show you how to perform a currency strength analysis and how to use the result of your analysis.
Have you ever asked yourself what currency trading is? If you ask others I think you’ll discover that most will tell you that its all about trading currency pairs. And while this is partially correct, on a more fundamental level it isn’t. Currency trading is about trading currencies, not currency pairs, at least if you want to get technical.
So why is this so?
This is due to the fact that each currency pair is made up of two independant currencies, hence expression a currency pair. So, when you trade a currency pair, you are ultimately taking a stance, one that anticipates that the pair will either move higher or lower. If the exchange rate of the pair goes up, this means that the EUR is increasing in value relative to the USD and vise versa if the pair goes down. This means that while the EURUSD (EU) may be going up, the EURJPY (EJ) may be going down at the same time, and this is because that trading currencies is all about the relative strengths of some currencies in relation to others. If we stick with the previous example, for the EU to be moving higher and the EJ lower, this simply means that the EUR is stronger than the USD but weaker that the JPY.
Why is this important?
This is very important because knowing how relative currency strength works will enable you to position yourself well in relation to which currencies you should be trading. Some currency pairs should not be traded because the relative currency strength of the two currencies is not diverging enough to take advantage of, which means that that currency pair is not moving – and getting into such a trade results in one typically watching price move up and down without really going anywhere. Performing a currency strength analysis helps solve this problem.
How does currency strength solve this problem?
Performing a currency strength analysis enables you to select currencies with diverging strengths so you can pair them. You take the strong currencies and you pair them with the weak ones. When you do so, you’ll see that particular currency pair move in one direction, towards strength and away from weakness, towards thinner liquidity and away from thicker liquidity.
How does one go about performing a currency strength analysis?
If we use the EURJPY pair as an example, you can look at all (or selected) currency pairs where the EUR is either a base or a cross and you can see what direction they are moving. Then you do the same for the JPY. I have done just that where I compared both currencies with the USD, EUR and the GBP, the results of which are presented below.
Looking at the EUR charts, is the price of the EUR going up or down relative to the USD, JPY and GBP? It looks like the EUR is being sold off relative to all three currencies.
Now, if we look at the JPY, is the price of the JPY going up or down relative to the USD, EUR and GBP? It doesn’t appear as if they all agree.
Now you know which of the currencies is most in charge, and thus which direction the price of this currency pair, the EURJPY, is most likely to move.
What can I use this information for?
You can use the result of your analysis to tell you which currencies are truly weak and which are strong. This greatly increases the chances of your trade succeeding, as price will often move in the direction your analysis tells you. And while we can’t all be economists, we don’t need to be in order to understand the market, as key figures such as unemployment, CPI and others are keyed into price. So, paying attention to currency strength will greatly improve your ability to identify which economies (currencies) to pair.
I don’t have time to perform a manual currency strength analysis, can this process be automated
Yes it can. I have compiled a video that shows how such an analysis can be performed using automated tools. You do not need them but performing an automated currency strength analysis as illustrated in this video is incredibly fast and effective, and it results in currency strength information, which can be used for any trading style. In this video I will show you how it can be used for swing trading.
I hope you found the information in this article useful – and if you have any questions, please feel free to contact us.