One idea that is often worth taking into consideration in our strategies is the concept of strength analysis among currencies. Let’s assume we want to work with four currencies (namely EUR, GBP, JPY, USD) and consequently with 6 currency pairs (EURUSD, EURGBP, EURJPY, GBPJPY, GBPUSD, USDJPY).
We introduce the concept of “relative strength” of a currency within a specific currency pair. As an example we want to estimate which is the strength of EUR relative to the currency pair EURUSD. Let’s say the strength is a number ranging from 0 to 100. If v1 is the value of strength of EUR within EURUSD, then (100-v1) is the value of strength of USD within EURUSD. In other words the sum of strengths of two currencies relatively to the same pair must be 100.
The following table shows the 6 relative strengths we are going to calculate:
A this point we have the strength of each currency within each pair. As an example the strength of JPY within USDJPY is (100-v6). The “absolute strength” of a currency is the average value of its relative strengths among the pairs it is involved with.
The following table shows how to calculate the absolute strength of each currency:
I haven’t said yet how to calculate v1, v2, …, v6. This can be done in many different ways, but basically we need an indicator that returns a value in a fixed range (an “oscillator”). Then we must decide the period and timeframe of such indicator. Therefore we can have many different “strengths” depending on the indicator, parameters, and timeframe we choose.
How to apply this info to our trading strategy?
I suggest at least two approaches:
1) filtering trades of your current strategy depending on the strength of currencies involved. As an example, if your system gives a buy signal on EURUSD, but we know that EUR has a much lower strength than USD, then this trade should be probably filtered out.
2) building an entire automatic strategy based on the strength concept itself. As an example, a strategy that constantly monitors the 6 pairs EURUSD, EURGBP, EURJPY, GBPJPY, GBPUSD, USDJPY and enters a trade only on 1 pair at a time when a huge spread among strengths is detected (buy EURUSD if EUR is the strongest currency and USD is the weakest one in our analysis).
Andrea is going to publish a series of posts that analyse thoroughly this concept. He is also going to make available indicators for MT4 that are built upon these concepts. So stay tuned 😉