Playing Strong Currencies Against Weak Counterparts

[RichardCox 10]

One common mistake that is made by most technical analysis traders is to completely disregard all fundamental aspects of the assets being traded. This is clear in the regular assumption that chartists do not even need to know the identity of the asset before placing a position. The rationale behind this is that all of the necessary information is contained in the price action itself. But if we are truly trying to gain an edge on the market, it is important to have at least some fundamental information about the assets being traded. At the most basic levels, forex markets require the ability to pair strong currencies with weak ones. This allows the trader to capture the biggest possible moves at any given time.

 

Another mistake that is commonly made my technicians is to focus on one or two pairs, and then to look for new opportunities in those markets exclusively. For example, traders might believe that technical patterns tend to work best in the EUR/USD, or GBP/JPY, and then regularly monitor those patterns in isolation. This approach does carry with it the added advantage of being most familiar with the historical price data present in those assets, and with the general behaviors (such as high volatility, or a tendency to trend) that are expressed by those assets. But it also means that there might be better opportunities in other pairs that will be missed, and, on the whole, it will be very difficult to pair the strongest currencies with the weakest currencies.

 

Relative Values

 

It is true that in any market, we are always exchanging the value of one asset for another. If you buy a stock, there is an implicit suggestion that the trader believes the value of that stock will rise, more than the value of the original currency. But these relationships are more apparent in forex than in any other place, as it is much easier to structure both sides of the buy/sell relationship. If we are long in the AUD/USD, we are buying the Aussie and selling the U.S. Dollar. It is implied that we expect the relative value of the Aussie to overtake that of the U.S. Dollar. While this information is obvious to some traders, it should be understood that there are many active participants in the market that fail to appreciate these relationships.

 

In order to get the most “bang for our buck” in any position, we need to identify which currencies are on the verge of extreme moves. The first question any trader should ask is: Which currency is most overvalued, and which is the most under-valued? Once we have an idea of this, we buy the asset that is excessively cheap, and sell the currency that is overly expensive. One way of doing this is to look at the trending behavior. Currencies that are marked by long-term downtrends can be paired with those that are caught in a long-term uptrend. When using indicator readings, oversold currencies can be bought with overbought currencies. The main point to remember here is that forex trading is a constant “tug of war” battle, and the way of making the most money in any one trade is to identify points of extreme weakness in one area, and strength in another.

 

Identifying Strength and Weakness

 

In the charted example, we look at the three majors: EUR, JPY, and USD. For the sake of argument, let’s assume that these are the only three currencies that exist. Which is the strongest? Which is the weakest? Which trade makes the most sense? The third question here, of course, is the most subjective and will depend on your general strategy approach. For example, a trend following trader would have a very different answer when compared to a contrarian, or swing trader. The first two questions, however, are much less subjective and can be answered relatively easily.

 

In the USD/JPY chart, we can see a clear rally on the charts. Many technical will stop right here and say the identity of the assets is meaningless. But knowing that we are looking at the USD/JPY carries with it some clear advantages -- especially when we compare these moves to our other two charts. A rallying USD/JPY denotes a strong Dollar and a weak Yen. The second chart shows sharp declines in the EUR/USD (again, a strong USD, and a weakening EUR). The third chart shows a modest rally in the EUR/JPY. All of these charts are taken on the same time frame (hourly perspective).

 

In order of relative strength, this tells us that, in the current environment, the US Dollar is the strongest currency, followed by the Euro, while the Yen is the weakest. This is because the Yen is falling against all counterparts, which the US Dollar is rising against all counterparts. The Euro splits its relative strength and weakness down the middle.

 

The Basket Approach

 

In some cases, it will be easier to identify one side of this equation (a currency ready to make a big move either upwards or downwards). It might be easy to determine which currency is strongest, but not which is weakest (or vice versa). In these cases, it might make sense to split your positions. In these cases, traders might want to take a more diversified approach, and play a few different currencies for (or against) the currency that is showing the clearest tendencies (either toward strength or weakness. When this is done, however, it is important to scale down leverage levels, as multiple positions for or against a currency will equally magnify the potential for losses.

 

Sentiment Indicators

 

Another approach is to watch sentiment indicators, such as the Commitment of Traders (COT) report, which shows the number of open positions in a given currency. In addition to this, many forex brokers will offer similar data, showing the number of bullish or bearish traders active in the market. These numbers are often given as a percentage, so a 50/50 reading would suggest the number of buyers and sellers in the currency are equal. When sentiment becomes extreme (i.e. above 80% or 20%) for a certain currency, trends are likely to reverse. This is because there is a small number of available buyers or sellers left in the market, and little reason to suggest that the current trend can find new reasons to continue.

 

All too often traders make the mistake of catching onto a trend as it is reaching its mature levels. A famous example of this can be seen in the tech stock bubble of the late 1990s, where many inexperienced traders bought-in at the highs, thinking there would be no end to the bull rally. In cases like these, it is important to see how the majority of the market is positioned, as this will give you a good indication of whether or not the market needs to correct itself.

 

Conclusion: Identifying the Weakest and Strongest Currencies Makes the Most Profitable Trades

 

It can be easy for technical traders to view certain markets in isolation, and miss opportunities that can be found when relative comparisons are made. The surest way to make the most profitable trades is to pair the weakest assets with the strongest, as your gains will always depend on the relative valuation of the assets you buy and those you sell. Here, we have strategies for making these determinations, and this information should always be considered (even by the most “purist” of chart technicians).

[SunTrader 10]

Note: 3rd chart is mistakenly labeled EURUSD and not EURJPY.

[tradingwizzard 10]

I agree with the article overall....however, taking in account COT is one things, but should consider the fact that data is not generalized.....it only belongs to that respective broker

[RichardCox 10]

Note: 3rd chart is mistakenly labeled EURUSD and not EURJPY.

 

 

Yes, thank you. The third chart is EUR/JPY, not EUR/USD.

[RichardCox 10]

I agree with the article overall....however, taking in account COT is one things, but should consider the fact that data is not generalized.....it only belongs to that respective broker

 

Good point, but this data is often indicative of what is happening in the broader market as well.