Another example of a forex relative strength overlay
I look at concept of relative strength between currencies over a duration and how traders can overlay forex pairs to pick the winning trade. This is an example that supplements what I have written about this topic ‘See relative strength, pick winning forex trade from an overlay‘.
The key to building an overlay is to start with an idea. When we think of strengthening DXY, we associate with buy USDxxx or sell xxxUSD. This is a common association or reflex action.
There are many possible trades to execute a long Dollar trade. Long USDJPY could be a choice but it could also be long USDCAD. Hey why not short AUDUSD?
It turns out many of us would come up with an idea – like ‘Dollar is strengthening so shorting EURUSD might be a good idea because EUR looks like it’s in trouble anyway‘ – then we go about to analyse an EURUSD chart. And then we execute the trade.
Over long, this might work. It’s not wrong but in my opinion the process could be more scientific. Fact is many of us are poorly equipped to deal with too many pairs at the same time but plucking a pair out of an idea/gut-feel is not really the basis for long term outperformance.
Overlay your favourite USDxxx and xxxUSD
Once you have decided that DXY is ready to resume it’s uptrend and has found it’s turning point, build your overlay. This is central idea to begin with.
Reminder: you can look up the method here. For learning purpose I will use the chart below but you can really build your chart any time. In fact the moment you found your DXY turning point on 02 February (marked by red arrow↑), you can build your overlay 24 hours after.
Start your overlay from 02 February 2012 (turning point). Overlay your favourite currencies. Some of them you may have to invert so that you can do an apple to apple comparison. In this example, the inverted pairs are USDEUR, USDGBP, USDNZD and USDAUD.
Do a visual inspection. The ones on top are strong-Dollar pairs. The ones below are weak-Dollar pairs. In this chart, USDEUR and USDGBP are the strongest and USDAUD is weakest.
This means that short EURUSD or short GBPUSD turned out to be sound decisions but short AUDUSD is a loser because USDAUD turned out to be negative over this period of time.
If USD had positive gain against all the currencies here, short EURUSD and short GBPUSD would be the best trade. It turned out that USDAUD lost money over this duration and means that AUD was really stronger than the USD.
A winning trade is the trade that buys the strongest – sell the weakest. In this real example of a period of rising DXY, the best trade turned out to be short EURAUD or GBPAUD.
This chart below shows movement of EURUSD, GBPUSD, GBPAUD, EURAUD from 02 February till date. A trader who did a short GBPAUD or short EURAUD trade has 3 times performance during this duration against short GBPUSD and EURUSD although the latter were good trades too.
Biggest surprise however was the best trades did not involve the USD. This does not fit our common association or reflex action. This is evidence that we can make better trade decisions by following a process.
Note these pointers when you use an overlay
- A trend may or may not continue.
- That’s why there is this disclaimer that past performance is not equal to future performance.
- A relative strength overlaying every pair like this lets us see strength of different currency pairs visually so that the best trade ‘jumps out’ visually.
- It is a scientific way to handle many levels of information by stacking into one.
- However the outcome is high-probability but NOT 100% percent probability.
- The good thing in this example if you look at the left side of this chart again was right from the ‘GO’ on 02 Feb (DXY found it’s turning point) AUD already clearly demonstrated it’s strength and GBP, EUR clearly showed their weakness.
- Short GBPAUD and EURAUD were clearly winning trades that were available for picking as early as 03 February.