Currency Strength Indicator has the ability to help traders avoid needless hedging and double exposure. Also, it can determine the risk level of the trades you have just entered.
The concept of trading currencies in pairs sets the currency market in a class of its own. Trading currencies are therefore quite different from trading any other asset class.
When you trade currencies, you are exposed to not one currency, but a pair of currencies. While this presents a number of lucrative opportunities, it also requires the development of special skills on the part of the trader. One of these skills is the ability to measure the strength or weakness of various currencies.
Since currencies are traded in pairs, it becomes very difficult for the trader, especially the beginner, to gauge the performance of just one of those currencies. For example, if you learn that USD/JPY is gaining fast, you may find it difficult to determine whether the pair is gaining because of the strength of the USD or the weakness of JPY.
But there is guidance to this difficult problem of measuring currency strength and weakness, and this guidance comes in the form of a technical indicator that goes under the name of currency strength meter or currency strength indicator.
What is Currency Strength
The currency strength meter is a graphical representation of the strength or weakness of currencies in the Forex market. Traders can use currency strength to predict currency movements when making forex trading decisions.
Looking at which currency is under or overvalued is an excellent additional signal or filter in technical analysis.
Realtime exchange rates are used to measure the aggregate, comparable strength. Simple meters may not use weighted calculations, while more advanced ones use their weighting factors. In addition, our calculation method shows the direction of the change (pointed with an arrow close to the name of the currency).
How does the currency strength meter work?
Those who don't know what currency meters do - they measure main currencies' strengths in the Forex market (USD, GBP, EUR, CHF, JPY, CAD, NZD, and AUD) by comparing all 28 crosses between them. It's a quick way for Forex traders to see whether market conditions positively or negatively affect their positions.
Let's look at how this technical indicator works and how it can help traders make informed trading decisions
There are five steps in all:
- Identify the base currency.
- Match the base currency with all available Forex pairs.
- Calculate the relative strength of each paired currency.
- Calculate the average score.
- Use the result.
The basic idea of the strength meter is to think of it as a "filter" in decisions. It allows us to determine, for example, whether the US dollar is strengthening or weakening, which is always essential to know.
Another thing to note is that a particular currency's strength is always determined by the timeframes you set for it. For example, EUR can be solid for today's timeframe, but it is one of the weakest on the list in monthly analysis.
How to trade FX with the Currency Strength Meter?
If you are trading in the trend direction, get the most robust trend based on the pair with the strongest and weakest currency. If you want to trade in a range, you can choose currencies where there is a slight difference in strength.
The way recommended by the professionals is to use a forex strength meter as an additional confirmation.
Reasons to Use Currency Strength Indicator
In the first place, a currency strength indicator is a simple tool that is very easy to use. As a short-term indicator, it is invaluable. It has the ability to help traders avoid needless hedging and double exposure. Also, it can determine the risk level of the trades you have just entered.
However, its biggest advantage is that it is available free of charge although you have to pay to get hold of the more complex currency strength meters in the industry.
The following are the details:
Useful Indicators for Short Term Trading
Professional traders usually use currency strength meters as indicators for scalping and day trading as they quickly guide traders to currencies that are gaining. Since they present an accurate picture of the current strength of a currency, they become very useful for short-term speculations. Some traders also use them to verify the data they obtained from other indicators.
Easy to Use
Currency strength meters are very easy to understand and use. They are more popular among new traders for this reason. Even if you are not a market expert and still have tons to learn, you can easily understand currency strength meters as they are simple visual displays that tell you exactly which currencies are doing well and which are underperforming.
Free of Charge
As previously mentioned, you will have to pay for sophisticated currency strength indicators that use complex data to deliver accurate signals. But most of the simplest and most effective currency strength indicators are available absolutely free of charge. Most are available as plugins and can be added as custom indicators in most of the trading platforms available today.
Advantages of Currency Strength Indicator
A currency strength indicator has three major benefits
Protection from Double Exposure
Since high correlation assets move in the same direction, you will end up overtrading if you enter multiple trades on highly correlated pairs. In such a case, you will lose a lot of money if the market refuses to move in your favor. For example, you will be at risk of double exposure if you go long on currency pairs such as AUD/JPY, EUR/JPY, and AUD/CHF if these pairs are highly correlated.
You will gain double exposure to JPY and AUD, which will lead to a huge loss for you if the market moves in a direction opposite to the one you predicted. A Forex currency strength indicator will alert you of such exposure because it gives you a simple graphic presentation of highly correlated currencies. You can, therefore, avoid trading these currencies and protect yourself from the risk of getting double exposed to weak currencies.
Prevents Needless Hedging
Traders can easily avoid needless hedging if they know in advance about the correlation between various pairs of currencies. Consider, for example, the currency pairs USD/CHF and EUR/USD have a negative correlation.
When you know in advance the negative correlation between these pairs of currencies, you will know that the market movement of these currency pairs is in opposite directions. So if you long trade both these pairs, you will lose one of the trades although you will win another. In this way, currency strength meters save you from needless hedging.
Identify High-Risk Trades
Currency strength meters can also help you identify the risk level of the trade you just entered. Consider, for example, that you are planning on going long on the currency pairs GBP/USD and EUR/USD. There is a positive correlation between these currency pairs, indicating double risk if the strength of one of the currencies is stronger.
There is also another possibility. One of the currency pairs may indicate a strong market movement while the other may indicate ranging. This is a clear signal to traders to avoid trading correlated pairs with opposing market movements.
For instance, if GBP/USD is ranging and EUR/USD is fast falling, you should not go long on the former as this pair is strongly associated with the risk of falling because the USD could be stronger.
Disadvantages of Currency Strength Indicator
Despite their benefits, a poorly coded currency strength meter can generate a number of issues.
If you have found a currency strength indicator that does not give you the accurate strength value of a currency, you just won’t be able to make a successful trade. An outdated or badly coded currency strength indicator can lead to freezing, wrong signals, memory leakage, stutters, and the CPU constantly working at 100 percent.
Some of them might just not function the way a proper currency strength meter is supposed to. Some of them use additional filters such as MACD, RSI, and moving averages as a result of which, they generate the wrong signals. If traders trust these signals, they will end up entering the wrong trades at the wrong time and losing a lot of money.
The most important point to understand is that currency strength indicators give you a small piece of information. You have to take that piece of information about the strength or weakness of a currency and see how it fits in the larger picture.
Find out if there is anything that supports the story the currency strength meter is trying to tell you. Ascertain if the currency meter is giving you accurate information.
Putting it in brief, you have to understand that the currency strength meter is nothing but a technical tool, which has to be used along with a number of other tools. It is best used to either confirm or complement the information other indicators and trading tools are trying to give you.
Importance of Correlation in Calculating Currency Strength
Correlation plays an important role in giving you the correct measure of a currency’s strength. You will not come across any of the issues mentioned above if you find a currency strength indicator that has been coded with the help of the latest trading technologies.
In fact, correlation is so important that the latest currency strength meters are actually currency correlation matrices capable of delivering accurate and complex data. Correlation simply points out the correlation between the currencies in a pair. To put it in financial terminology, correlation gives the numerical measure of the relationship between two currencies. The correlation coefficient is always in the range of -100 to +100.
If the correlation of a pair of currencies is +100, it indicates that the market movement of both currencies will be in the same direction. If the correlation of a pair of currencies is -100, it indicates that the market movement of both currencies will be in the opposite direction. A zero correlation indicates an arbitrary relationship between the two currencies.
High correlation currency pairs are always strongly linked together. Positive correlation currency pairs exhibit market movements in the same direction, and negative correlation currency pairs exhibit market movements in opposite directions.
As explained in our Forex Trading for Beginners guide, depending on how they behave, these major currencies are classiﬁed as one of two kinds: risk and safety or safe-haven currencies. For now, just know that in general:
- Risk currencies are those that appreciate in value in times of optimism and depreciate in times of pessimism like other risk assets such as stock indexes or industrial commodities.
- Safe haven or safety currencies depreciate in times of optimism and depreciate in times of pessimism like other safety assets that are in demand when markets are fearful, such as investment-grade bonds.
But how is correlation used to calculate the strength of a currency?
Correlation can be used to measure currency strength because we trade currencies in pairs. Consider, for example, that the correlation of EUR/USD and USD/CHF is -76. This indicates a negative correlation. The market movement of the two pairs is most likely to be in opposite directions.
If you trade long on these pairs or even if you trade short term, your losses will cancel out your gains. To explain this further, you will be hoping to profit from the fall of the USD if you trade long on EUR/USD. On the other hand, you will be hoping to profit from the rise of the USD if you trade long on USD/CHF.
Owing to the high correlation between the two pairs, we can calculate that the currency that is common to both these pairs, GBP, is the strongest currency.
Tips to Use the Currency Strength Meter
Using the currency strength meter to boost your trades is a work of art. You must understand that currency correlations are constantly changing. You cannot use a currency’s previous performance as an indicator to predict its correlations in the future. But as an expert trader, you can use this valuable information to create an effective trading strategy and minimize the risk to which your trading portfolio is exposed.
Here are some tips that help you use the currency strength meter better:
- Avoid Entering Trades that Neutralize Each Other: Avoid going long on two pairs of currency that are clearly moving in opposite market directions. Your loss on one of these trades will potentially nullify your profits on the other.
- Minimize Risks: If you invest in two pairs of currencies with a positive correlation, you can potentially minimize your risks.
- Minimize Losses: At the same time, you can minimize your losses if you hedge two pairs of currencies with a negative correlation that is close to perfect. If you trade a pair of currencies that is losing value, the pair that is in negative correlation to it is sure to gain. You won’t be eliminating losses if you use such strategies, but you will definitely be minimizing your losses.
While using the currency strength meter, avoid the following mistakes:
Don’t Use It Without Knowing How It Works
The biggest mistake that forex beginners make is using currency strength meters without knowing how they work. Like all other trading indicators, currency strength meters function on the basis of a formula, which helps it determine the weakness or strength of currencies. You can trust the currency strength indicator and the information it reveals only if you thoroughly understand this formula.
Several things can go wrong with a currency strength formula. The formula that governs it could be all wrong. Or it could be coded to function only on daily timeframes, and you could be unknowingly using it on lower timeframes.
Irrespective of the trading tool or technical indicator you choose to use, you should use it only if you know and understand the formula on which it works.
Don’t Time Trade Entries on the Basis of Currency Strength Meters
Avoid blindly exiting and entering trades based on the information the currency strength meter gives you. For example, you use the currency strength meter to find out the strongest pairs of currencies at present and make a quick buy. You think that the currencies will get stronger.
In this case, you are making a big mistake. Currency strength indicators are meant only to inform you about the strength and weakness of currencies within a particular time frame. This is, by no means, a signal for you to enter or exit a trade.
If you make this mistake, you will be chasing markets that have already moved a lot. You cannot place an effective stop loss, and the chances of you being exited from a trade are high when the prices drop.
False Signals are Usually Sent on the Lower Timeframe
Currency strength meters calculate price change within a given time frame to determine the strength or weakness of currencies. When done on the lower timeframe, it leads to the wrong signals.
This is because important forex news can lead to a sudden rise in price, which currency strength meters use to calculate the strength/weakness of a pair of currencies. For this reason, you should always use currency strength meters that calculate price change from higher timeframes.
How to Create Your Own Currency Strength Meter
If you are unable to trust the currency strength meters in the industry, you can create your own currency strength meter. All currency strength meters calculate price changes within a given time frame and use them to determine the strongest and weakest pairs of currencies. You can add to your currency strength meter more formula and weighting.
The simplest currency strength meter, however, does not require any complicated algorithms and formulae.
- Step #1: You have to first make a list of major pairs of currencies.
- Step #2: Your next step is to calculate the changes in percentage during the last 15 weeks. To do this, you just have to insert the rate of change (ROC) indicator into the weekly time frame and change its settings to a 15-week period.
- Step #3: Finally, you have to rank the currencies from the strongest currency to the weakest currency. You would be placing the pair getting the highest value right at the top, followed by the pair with the next highest value, and so on.
Before getting started in FX, you should be aware that the market is susceptible to prominent levels of volatility and as a result, an asset might experience a breakout or breakdown in a short space of time.
As a result, you should carry out both technical and fundamental analysis on the asset you want to trade before you open a position.
If you want to practice forex trading in a risk-free environment, you can open a demo account with CAPEX.com and start testing your CFD trading. Or, if you feel ready to start trading currencies on live markets, you can open an account and be ready to trade in less than five minutes.
We also offer educational resources like CAPEX Academy to help you understand trading and get to know the risks.
Users/readers should not rely solely on the information presented herewith and should do their own research/analysis by also reading the actual underlying research. The content herewith is generic and does not take into consideration individual personal circumstances, investment experience or current financial situation.
Key Way Markets Ltd shall not accept any responsibility for any losses of traders due to the use and the content of the information presented herein. Past performance and forecasts are not reliable indicators of future results.