Wednesday, April 27, 2011

Basics of Trading Currencies Based On Relative Strength, Part I

Currency trading has grown exponentially over the last decade. That has given birth to a number of websites, blogs and twitter feeds that are all aimed at educating traders. Whether it's fundamental or technical trading that's being taught, more often than not the authors of trading strategies fail to mention trading based on relative currency strength. The following is an overview of relative strength trading and what you can expect to find from this blog.

Relative Currency Strength 
Trading currencies based on relative strength can be summarized as finding the strongest and the weakest currencies and playing them against each other for profit. It is a relatively straight-forward strategy that doesn't require drawing fibonacci extenstions, trendlines, support and resistance areas or the use of technical indicators. Although one doesn't have to use the above mentioned tools for analysis they should not be cast aside as they can offer valuable information about potential entry and exit points. I will be writing about combining conventional analysis methods with relative strength analysis in the future. For now, let's go back to the basics.

For a better understanding of what relative currency strength really is, let's look at an example. Imagine the following:

EURUSD is rising
GBPUSD is falling
GBPJPY is falling
EURJPY is rising

Four pairs isn't exactly enough to determine the overall strength of the currencies featured in the above pairs, but for brevity and educational purposes, this will have to do for now. With this very limited info we can determine that:

EUR is strong, because it is rising against USD and JPY
GBP is weak, because it is falling against USD and JPY

We can't say much about the dollar or the yen because they are falling against the euro but rising against the pound. It could be that dollar is standing put and only the euro and the pound are moving, but it could also be the case that the dollar is rising overall, but the euro is rising faster thus making EURUSD rise as well. The only thing we can be sure of is that the euro is the strongest amongst the four currencies and the pound is the weakest.

As far as we know, the smartest thing to do is buy EURGBP.

Pairing the strongest against the weakest is the essence of relative strength trading. It is what banks and hedge funds have been doing for years. Of course you won't read about it on most websites, because most traders are drawn to fx trading in the false hopes of making a million dollars overnight without having to do anything and so the websites cater to those false hopes. The other reason is perhaps that the brokers don't really care if you make money or not.

Why Trade Like This?
Trading currencies based on their relative strength is nothing new, however it is very different from conventional technical trading. When trading EURUSD a trader usually identifies support and resistance areas, supply and demand areas and probably has a few chart overlays and/or indicators for additional help. The trader looks to buy when the pair is strong, but since there are two currencies involved one can never be sure about the origin of the strength or weakness of the pair.

If EURUSD is rising, it could be because
a) EUR is rising, USD is not moving
b) EUR is rising, USD is falling
c) EUR is rising, USD is rising (but slower than EUR)
d) EUR is not moving, USD is falling
e) EUR is falling, USD is falling (but faster than EUR)

So we have FIVE possible explanations for the rise in EURUSD. By looking at one pair in isolation a trader is missing out on crucial information that is especially important at or near turning points. A trader who is monitoring all major crosses is more likely to get out before a reversal than a trader who has his eyes on one or two pairs only.

Pairing the strongest against the weakest is also important when it comes to making money. Specializing on one or two pairs is what most authors writing on the topic usually suggest, but that is of little help on days when your favorite pair is ranging due to lack of market interest, slowly draining your account of accumulated profits when you could be trading a pair that is showing signs of life. Monitoring all the major currencies will not guarantee you will make money, far from it, but it shows you the way in terms of what pairs to consider in the first place.

Future Plans With This Blog
In the coming weeks I will be writing about the basics of trading currencies based on relative strength, featuring example trading opportunities along the way. I will also write about forex in general. This is still a new blog and I have not thought everything through in terms of long term plans, but stick around and I'm sure you'll have a great time. Use one of the 'follow' options to get new posts delivered to your feed reader or inbox in the upper right corner of the blog.