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This week’s question comes from Mimi, who asks:
How do you choose your pairs to trade and do you consider weak/strong currencies to pair and trade? I have found that many traders get “stuck” on the same pairs, but as currency traders we surely have to look at which currencies are weak/strong.
The only way we make money as currency traders is to find and exploit the strengths and weaknesses of one currency versus another.
Everything is relative, so the greater the divergence is between the two currencies, the more money we stand to make.
That’s the name of the game – find and trade the strongest currency against the weakest currency.
But to do that successfully, you need a quality buy or sell signal. You also need a solid plan.
Otherwise, you’ll quickly find yourself buying into resistance and selling into support. And with no plan or strategy in place, you’ll drain your trading account faster than you can say Forex.
But I’ve talked about strategies and plans before. Today we’re going to focus on relative currency strength. Specifically, how to find the strongest and weakest currencies to trade.
Currency crosses are one of the most overlooked aspects of trading Forex. Sure, they don’t offer the kind of liquidity as the majors, but when it comes to determining currency strength and weakness, they’re unparalleled.
A cross is any currency pair that does not include the US dollar. These include the EURGBP, AUDNZD, EURCAD and the EURAUD to name a few.
If you want to learn more about currency crosses, see this lesson.
Let’s assume for a moment that you’re considering shorting the EURUSD. The pair has been weak lately and looks poised to continue lower.
But a glance at the GBPUSD paints a similar picture. The pair is breaking down with no immediate support in sight.
So how do you choose which pair to short?
All things being equal, the EURGBP holds the answer. It’s going to help you determine whether the Euro has been and may continue to be weaker than the pound or vice versa.
Looking at the EURUSD and GBPUSD won’t give you that kind of insight.
Now, what do I mean by “all things being equal”?
With the example above, we aren’t concerned with technical patterns or price action signals. We also aren’t taking into account risk to reward ratios or scheduled news events.
Let’s take things one step further.
Using the same example, let’s assume the EURGBP looks relatively bearish. It’s been moving lower for a couple of months and appears to have room to continue lower.
With this new information, you decide that the Euro is the logical currency to short of the two. And I would agree with you, at least on the surface.
But here’s the deal…
We still need a valid trade setup if we’re going to short the EURUSD. Just because we’ve discovered that the Euro is likely to be weaker than the pound in the future does not justify an entry.
So you see, while this is an excellent way to determine the relative strength and weakness of non-US dollar currencies, it is not all-inclusive nor is it foolproof.
It’s merely a way to fine tune your analysis.
We can apply this same technique to crosses such as the AUDNZD, EURNZD, GBPNZD, etc.
While I love talking about this subject, it can be a slippery slope if you aren’t careful.
Let’s say you see the AUDUSD and NZDUSD heading south in a hurry. You take a look at the AUDNZD, and it too is plummeting.
Based on what we just discussed, you decide that the AUDUSD has more downside potential than its counterpart, the NZDUSD.
So you head over to your trading platform and sell the AUDUSD, hoping to capitalize on the apparent divergence.
But here’s the thing…
Where is support? Was there a valid sell signal? Where is your stop loss? What would negate the setup? Is there any scheduled event risk for the Aussie?
If these questions are left unanswered, you’ve just committed a Forex sin – you chased the market.
Worse yet, you chased the AUDUSD without the presence of a quality sell signal or a solid plan in place.
So you see, taking this notion of strongest to weakest currency out of context can be dangerous. That’s why it’s so important to keep things simple and always have a plan.
In fact, if you are just starting out, my suggestion is to forget about this entire concept of using currency crosses. It’s great information to have and can certainly help you plan your trades, but it isn’t vital to your success.
It’s my opinion that you should only consider using this technique once you’ve built a strong foundation using key levels and price action strategies.
The currency crosses are your key to discovering the strongest and weakest non-USD currencies.
But as useful as this technique can be, it’s important not to get bogged down by it.
A far better use of your time is to focus on things like key support and resistance, price action signals and technical patterns.
Like everything we do, keep it simple and always be sure that what you’re doing fits your style. Because it’s not about finding what works best, it’s about finding what works best for you.
I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.
To do that, I need your help.
Here’s what you can do to get involved and have your question answered in next week’s post:
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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