Determining the Best Trading Opportunities

Using momentum data derived from relative-strength studies of a basket of currencies, it is possible to calculate an average “exchange rate” involving any two currency families and plot its rising and falling action on a graph. If the rate is rising, the odds favor a long trade in the pair. If the rate is falling, the odds favor a short trade. This is valuable information to have, but by digging deeper into the data we can learn even more. Let’s assume we are tracking the GBP vs. the JPY and the momentum exchange rate we have been calculating is rising. Here are the potential reasons why this could be occurring:

1.GBP is rising;* JPY is falling.

2.GBP is rising, JPY is holding steady

3.GBP is rising, JPY is rising but slower than GBP

4.GBP is holding steady, JPY is falling

5.GBP is falling, JPY is falling but faster than GBP

* The actions of rising, falling or holding steady refer to the currency family’s performance against a basket of currencies.

Obviously, the combination with the greatest potential to generate a profit would the first: GBP is rising, JPY is falling. It goes without saying the trade direction would be long. This represents the ideal precondition for a trade since it involves one currency that is rising in momentum against a basket of currencies and another that is falling against the basket. The other combinations could also be traded, but from a relative-strength perspective, the degree of confidence in a positive outcome would be lower.

Profiting from Divergence

Imagine that a relative-strength analysis shows the GBP is gaining strength with increasing momentum against a basket of currencies while the JPY is falling in strength with increasing momentum. Looking at a price chart for the GBPJPY set to the same time frame as the analysis, you would notice that the trend has been bullish. However, what if the actual spot price is retracing against the trend? What should you do? According to our study, the trend would remain bullish as long as the GBP continued to strengthen against the currency basket and the JPY continued to weaken. This suggests the price retracement is only a correction, not a reversal, and could be used as an opportunity to open a long trade position.

Choosing Entry and Stop Levels

Relative-strength analysis does not by itself provide specific buy and sell signals. However, when used in combination with traditional technical analysis tools, it can give traders an edge in determining when to get in and out of a position. For instance, if a currency’s relative strength is bullish and the MACD is giving a buy signal, a long trade could be opened with a higher degree of confidence than if the MACD signal was the only basis for the decision. Conversely, if a currency’s relative strength is bearish and the MACD is giving a buy signal, the trader may wish to ignore the buy signal.

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