Updated: Sep 15, 2020
The retail foreign exchange market is booming as traders discover the benefits of participating in the world’s biggest financial market via online margin trading platforms. These platforms provide us with a level of access to the FX market that was simply impossible for all but the largest international banks and institutions just a few years ago. These days, it does not matter who you are or where you live, if you have access to the internet you have the ability to trade the foreign exchange market right alongside the biggest financial institutions in the world. The top 3 currency pairs account for nearly 60% of all FX market activity, again, far outstripping the turnover of the approximately 38,000 individual securities traded on the world’s stock exchanges.
FX trading always involves the simultaneous exchange of two different currencies. The two currencies involved in any particular transaction are known as a ‘pair’, such as USD/JPY, EUR/USD or AUD/USD. Whenever one currency is bought, the other currency in that pair is, by default, sold.
The best way to trade the financial market is to gain an edge over the markets.
This means putting the odds in our favour, which would increase the probability of a successful trade. One of the simplest ways to do this is to ascertain the trend of a particular currency by comparing it to its other related pairs. This is because a strong trend in a particular currency pair would generally mean that it is strong against the other currencies too.
For example, an up trending EUR/USD would probably mean a strong EUR/GBP, and so also the EUR/JPY. While this would hold true most of the time, it is not a rule and hence cannot be counted upon as a confirming factor. More than a simple correlation like this, a much deeper relationship between a currency pair, and its cross related pairs would give a better confirmation. What I have found more effective is to confirm the trend of a currency by looking for similar signs on its cross pairs. If a currency exhibits similar trends with a major and a cross pair, it is a safe trade.
But what about the time, when these two factors are not confirming? This kind of situation, in fact, provides excellent trading opportunities, as we can derive important clues from here. If this sounds confusing, bear with me, as we will go over it step by step.
The best example for this strategy would be the AUD. This is because it is traded actively with the USD – the AUD/USD and its cross - the AUD/NZD is also very actively traded and has high volatility. The objective of the strategy is to derive clues from conflicting situations of the AUD. We will compare all the currencies on the same time frame, and we first look at the Daily charts of the AUD/USD and the AUD/NZD, which are overlaid for comparison.
The AUD/USD line chart is the black line chart, and the AUD/NZD is the blue line chart. We can observe that prices move in tandem in both the charts, showing a fair degree of relationship between the two, shown by the blue arrows. So, anytime the AUD is in an uptrend against the USD, we should think of taking long trades in the AUD/NZD. But let us take a look at the situation (marked in the red circle) where this relation breaks down, and prices start moving in opposite directions.
For this particular time that we are looking at, we can see that the AUD/USD has started a downtrend even though the AUD/NZD is still in an uptrend. This means that the AUD is growing weaker…. and the USD is growing stronger. This throws up a conflicting situation, and we need to know if this AUD weakness will pass on to the AUD/NZD and will this pair follow suit and go into a downtrend? In this case confirming the AUD weakness would mean confirming the USD strength.
So we take the next step, and look at the Daily chart of the USD/CHF. I have chosen the USD/CHF pair, as this is often a leading indicator of the USD trend, plus it has very high volatility. Similarly, we overlay the Daily charts of the AUD/USD and the USD/CHF.
The AUD/USD line chart is the black line chart, and the USD/CHF is the blue line chart. And again, we can observe a symmetrical inverse relation between these two pairs shown by the blue arrows. We can similarly conclude that if the AUD/USD is strong, it will mean a weaker USD/CHF. So in this case, if the AUD/USD has started a downtrend, the USD/CHF must start to rally. But this does not happen.
Even as the AUD/USD starts dropping, the USD/CHF does not rally, but instead makes lower highs, shown in the red circle. This creates another conflicting situation, or a divergence, which gives us a warning that this downward movement in the AUD/USD may not last. As we observe the further price movement in both our charts, we observe that the AUD/NZD (in the first chart) continues making higher highs, and the USD/CHF (in the second chart) continues making lower highs.
This confirms our line of thinking, that the AUD/USD is due for a rally soon. This advance warning is an excellent trading signal, and I would look for a long trade on the AUD since I have the double confirmation. As we can see, the AUD/USD eventually bottoms out and rallies with a great momentum, shown in the black circle on both the charts. Only this time we were prepared for the trade.
Article as published in the Guppytraders.com weekly newsletter, June 21st, 2006 edition.