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Wednesday, January 25, 2012

Analysis of currency pairs in groups

This is one of the very few things that consistently worked when I was trading Forex during 2010. The Analysis of currencies in groups also known as Parallel and Inverse analysis of currency pairs is the technique that analyses a currency's strength or weakness based on the behavior of the pairs where that specific currency is involved.

Didn't get it? No problem, let's go with examples.

Let's say EURUSD is trending up on a certain day, and I have some other crazy indicator telling me to go long. Since it is my favorite pair and everything looks bright, I go long assuming that EUR is strong. Now, many times this is not enough evidence to consider the Euro strong. If other pairs such as EURJPY and EURGBP are trending down, that is evidence that the EUR is not strong after all. It is strong vs USD but weak versus everyone else. In such scenarios, many times, going long EURUSD doesn't offer a significant trading edge as EUR is not strong enough. To assume that the EUR is strong, all three pairs EURUSD, EURGBP and EURJPY should be trading upwards and that is a confirmation that Euro's strength is the force driving the markets. Otherwise there is someone else driving the market during the day, not our beloved Euro.

Second example:
USDCAD trending up
AUDUSD trending down

The USD is strong in both cases. It is the force driving the moves. The ideal trade is to go long USD versus someone, the weakest between CAD and AUD. You would need to analyze then AUDCAD. If it is trending up, CAD is weaker so the ideal trade is long USDCAD. If, on the contrary AUDCAD is trending down, AUD is weaker, and the ideal trade is short AUDUSD.

Third example:
USDCAD trending up
AUDUSD trending up

Obviously USD is not strong enough. It is mixed as it is strong vs CAD but weak vs AUD. As USD is mixed, that is, neither strong nor weak, it is better not to trade it. The USD is not the force driving the markets here. The best pair to trade in this situation is long AUDCAD. As AUD is strong and CAD is weak.

Let's complicate things with a fourth example:
AUDJPYtrending down    AUD weak, JPY strong
AUDUSDtrending up    AUD strong, USD weak
USDCHFtrending down    USD weak, CHF strong
CHFJPYtrending down    CHF weak, JPY strong

What's the ideal trade here?

Let's analyze each one of the four currencies one by one
(AUD) Is it wise to go long AUDUSD in this environment? It is not clear. AUD's strength is questionable as it is not strong across the line, given that it is weak in front of the JPY.

(USD) USD on the other hand looks weak, as it is weak vs AUD and also weak vs CHF. This is the currency to short as it seems week across the line. But we need to find the ideal counterpart to go long vs USD and we already now that AUD is not the ideal one.

(CHF) We can't say that CHF is weak or strong today, because the sentiment is mixed. CHF is strong vs USD given that USDCHF is trending down, but at the same time CHF is not totally strong as it is losing vs the JPY. CHF is not the ideal currency to go long here. Similarly to AUD, it is not strong across the whole spectrum.

(JPY) The Yen is strong versus the Aussie (AUD) and it is also strong versus the Swiss Frank (CHF). Without question, JPY is the strongest currency, and given that USDCHF is trending down and JPY is stronger than CHF, then the combination USDJPY offers a clearer and more solid downtrend without need to look at the USDJPY chart. We are matching the strongest currency of the day with the weakest one, and that set up offers the best probabilities of success.

By analyzing currencies in groups, a trader can match the strongest currency of the day with the weakest one, and that will offer an edge that should result in profitability over the long term. However, very few forex traders look at the Forex market this way and they are instead trapped in the EURUSD slavery, or another currency pair of choice combined with some technical indicators, forcing trades most of the time when there is no clear edge. With this system, the trader doesn't fall in love with one currency pair and needs to be flexible and ready to trade any pair regardless of the fact that it involves the USD or not, or even a pair that he/she has never traded before. The other disadvantage of the system is that spreads for uncommon pairs tend to be a little wider, but that shouldn't be a huge problem if the trades entered are not scalping trades but instead aim to achieve a greater number of pips and over longer time-frames.

Ok, very pretty Henrik. But where can I find this information? When do I know if a currency has gone from mixed to the strongest or weakest of the day? Also, when you analyze two, or three pairs like I did here, it is relatively easy, but how about when you analyze all the combinations between all 8 major currencies? Suddenly drawing conclusions and knowing the strongest of the day and the weakest of the day becomes more tricky and time consuming. And that's where Forex Early Warning comes into play.

Forex Early Warning offers the Forex Heat Map, a visual tool that allows you to visualize slingshots immediately (slingshots are the combination of weakest vs strongest currency of the day). FEW also sends a trading plan every morning and every night. On top of the Parallel and Inverse Analysis, they use support and resistance in their strategy. They advise to enter long trades only when resistance is broken, and short trades only when support is broken. Accordingly, their trading plan consists of price alerts that you need to set up on your trading platform. When/if the price alert is triggered, that means either a support or resistance level was broken. At that point you should consult the HeatMap tool to verify the overall weakness and strength present on the currencies involved so you can decide whether to enter or not.

I'm not affiliated with FEW or anything. But I'm sick of market gurus and crappy forex systems being sold and scamming newbie traders. I was there myself and that's why I share these things. I do think ForexEarlyWarning has a model that works, and a no BS approach to trading and promoting themselves. From all the things that screwed my performance in Forex I could quickly learn that the vast majority of the offers on the internet are worthless garbage. Unscrupulous marketers after yours and my money.

By writing this blog-post I expect to somehow share what I consider valuable knowledge and contribute with ForexEarlyWarning as I think their honesty and their system deserve some more recognition and publicity. There is no strategy that wins 100% of the time, you will have your bunch of losers with this one as well but I think this type of analysis could give you a powerful edge.

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