Incorporating a currency strength indicator into your trading strategy can be rewarding. However, it is crucial to understand its functionality and usage before implementation. As with any tool, it is essential to comprehend its workings and application.
For this purpose, we need to dive into the nitty gritty as well as the boring stuff. In this post, we will learn about the various calculation methods and usage of the currency strength indicator.
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The currency strength indicator is useful for filtering trades, timing trade entries, and evaluating open positions regularly. And it should provide the strength or weakness of each currency compared to other currencies used in the calculation, for the specified timeframe.
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Think of it as a league tournament of your favorite individual sport. Every player has to play against every other player in the league. At the end of the tournament, you will have the rankings from the best or strongest player to the weakest.
If you noticed, each player represents a currency and each match represents a currency pair.
Although the concept is the same, there is no unique standard method of calculation. There are many types of currency strength indicators using various calculation methods. In other words, you decide the rules of the game.
Currency strength calculation
In this post, we only consider currency strength calculation methods based on technical analysis.
To understand different strength calculation methods, we need to go back to the basic unit comparison within a single currency pair.
Price of a currency pair
The value of a currency is always comparative. Without a quote currency to compare with, the base currency can never have a numerical valuation. Going back to our analogy, this means a “no match” situation.
The price of a currency pair means the amount of the quote currency that can be exchanged for 1 unit of the base currency.
EUR is the base currency and USD is the quote currency in the EURUSD currency pair.
EUR/USD = 1.2345 1 EUR = 1.2345 USD
According to this basic principle, a positive price movement of a currency pair also means the base currency is strengthening against the quote currency and vice versa. A price candle translates to a single match between 2 players (or currencies) in our analogy.
To establish the strength or weakness of a currency compared to another currency, we only need to look at the price chart of that specific currency pair. The recent history of price is an indication of the strength or weakness of each currency.
Ranking currencies by strength is pretty straightforward when it’s only for 2 currencies. However, it becomes a little more complex to rank 3 or more currencies by relative strength.
Currency strength is relative
The currency strength indicator in technical analysis is a relative indicator. To rank USD, EUR, and GBP currencies according to their strength, we need to consider all 3 possible currency pairs between them: EURUSD, GBPUSD, and EURGBP.
Depending on the number of currencies being compared (n), the number of currency pairs to analyze is derived from the following formula.
Number of currency pairs = 0.5n(n-1)
For example, to compare the strength between all 8 major and commodity currencies (USD, EUR, GBP, JPY, CHF, AUS, NZD, CAD), we should take 28 currency pairs into the calculation.
0.5 * 8 * (8-1) = 28
Calculation method 1: Movement of price in pips
Currency strength indicator calculation is done by aggregating the price movement in pips, within the last candle on all relevant currency pairs. Bullish movements are positive and bearish movements are negative.
EURUSD = -20 pips GBPUSD = 30 pips USDJPY = 75 pips USDCHF = -109 pips AUDUSD = -32 pips NAZDUSD = +54 pips
When aggregating, if the subject currency is the quote currency in a pair, then that value is subtracted.
Total aggregated pips -(-20)-30+75-109-(-32)-54 = -66
Then the outcome is expressed as a percentage of the total number of pips.
Total pips (unsigned) 20+30+75+109+32+54 = 320 pips USD strength 100 * ( -66 / 320 ) = -20.625 %
But this value is purely meaningless unless, of course, the same operation is carried out on other currencies to get their respective percentage strength.
Then we could rank all currencies by the order of the percentage outcome.
Calculation method 2: Points aggregation
The approach here is to assign points according to the movement of price during the specified time period.
EURUSD = -20 pips EUR -1 points USD 1 points
If the net price movement of the instrument is bullish, then the base currency gets +1 point and the quote currency: -1 point. If it’s bearish, then the base currency gets -1 point and the quote currency gets +1 point.
If the net price movement is 0, then none of the currencies get any points.
Now we have the list of currencies with their respective aggregated points, so we can order them from the strongest to the weakest.
This method is perfectly in line with the league-tournament analogy. Just like the players get points for winning a match, the base currency is considered the winner when the price movement is bullish.
Currency strength calculation: continuous curve
This is not a different type of calculation, but a detailed continuous elaboration of the currency strength as a curve. Both the methods above would give the strength or weakness of currencies at that moment (e.g. at the end of the last candle).
Taking it a step further, connecting the strength at regular intervals (e.g. every candle close), provides a curve on the fluctuation of the strength over a period of time.
This is the EURUSD chart. The red line represents the USD and the blue line represents the EUR. Three takeaways from reading the currency strength MT4 indicator on EURUSD live chart:
- Every time the USD increases in strength, the EURUSD price falls or goes into a mini correction.
- USD strength was always above the EUR strength for the complete downtrend correction
- EUR strength is consolidating steadily during the whole time.
Live chart currency strength indicator can indeed give more insight into the momentum and direction of strength fluctuation of major currencies.
Caveats in the technical calculation of currency strength indicators
Before we jump right into the use cases, it’s important to note the attributes and context of the currency strength calculation.
- Period or the number of candles considered in the calculation.
The outcome is just a representation of that period only. It could have been affected by one-off events such as monthly or quarterly financial news.
- Calculations are based on past data (even if it’s the last candle). So it is a lagging indicator… unfortunately.
We know how quickly things can change in the forex market. Forex strength meter is no different.
- Emphasis on the timeframe
Different timeframes can produce opposite strength indications. Just like there can be opposing trend directions between timeframes (for the same number of bars on each timeframe), the forex strength meters too may produce opposing values on different timeframes.
How to use the forex strength meter
Now to the juicy part… how can we use forex strength meters to maximize trade profits? Well, all 3 stages of trade could use the strength meter.
A word of caution though. This is not an end-all, be-all metric, and should be treated as yet another edge to push the probability in our favor.
1. Trade entry (open order)
Suppose your strategy gives a buy signal on EURUSD. Assuming you trade on the daily chart, and the currency strength indicator’s daily value (last candle) shows a very strong USD, then it means you have to consider passing on the trade.
On the other hand, if the daily currency strength indicator shows a weak USD and a very strong EUR, then the trade call is endorsed by the strength indicator. Thus, the trade order would be placed with confidence.
There’s also a whole different approach to accommodate a forex strength indicator to the daily trading routine. It is by starting with the strength comparison.
If you are familiar with trading a diverse portfolio, then this method is ideal for you.
Start by analyzing the currency strength indicator daily. Then pick the currency pair with the strongest and the weakest currencies. Look for trade signals confirming to the “strength indications” of the currencies.
If JPY is the strongest of the lot and GBP is the weakest, then you could look for sell opportunities in the GBPJPY currency pair.
This way, you can be certain to trade the pair with the biggest strength gap, thus having the opportunity to catch sharp moves in the direction of your trade.
2. Trade Evaluation
Institutional or position traders (big fish) use hedging strategies to protect their open positions. With currency strength analysis, retail forex traders (small fish) like you and me too can use similar hedging strategies.
Let me explain in detail… suppose you have a trade open based on the weekly chart. Let’s say a long position on the EURUSD. Now this trade would stay open for many weeks, 2 weeks at the very least.
In the meantime, we can refer to the currency-strength meter on the daily candles, regularly.
Price never travels in a straight line.
Especially with a weeks-long long trade open, we have to expect many dips and turbulences until the target is hit. This is where the constant observation of the daily currency strength comes in. When the USD strength is increasing compared to the EUR, it means the EURUSD could go into a temporary correction in the shorter term.
The idea is to look for short-term intraday short opportunities when the price dips on the longer-term long position.
For this method to work, intraday trades should be based on the momentum and the direction of strength, rather than the currency strength value itself.
3. Trade exit
By trade exit, I mean a premature exit from open trades, not necessarily as the actual exit strategy. While the currency strength indicator can be used as the exit strategy, it’s ideal as the backup tool.
It is the doctor that gives a second opinion. When an open trade shows exhaustion and a stagnant equity curve, perhaps the tides are about to change. And it’s worth a look at the currency strength for confirmation of these uncertain circumstances.
Although the currency strength indicator has a few flaws, it does give insights and comparative strength measurements. Multi-currency relative strength analysis is an invaluable tool to have in trading.
Because the difference in strength or weakness of currencies is what moves the markets. The bigger the gap, the sharper the move.
So currency strength indicator gives strength to traders. After all, we do trade to catch these sharp moves.
The currency strength indicator is also a great addition to a confluence trading strategy. Check out the post about confluence trading to learn more.