By Sam Evans, Online Trading Academy UK Forex, E-mini, and Power Trading Workshop Instructor
Forex trading has many benefits, including great leverage, 24Hr markets and more transparent Fundamentals. In the ongoing XLT - Forex Trading sessions, I regularly talk about these benefits and each and every student in the class makes the most of these advantages on a day to day basis. We go through the importance of having a detailed understanding of Supply and Demand, managing trades unemotionally and scouting the markets for only the Lowest Risk, High Probability opportunities on offer. Throughout our ongoing live market analysis sessions, we also pay attention to the distinct correlations between various currency pairs and a variety of others markets, like Treasury Notes, Gold, Oil and the S&P 500 stock market itself. To acquire a good level of success in Forex trading, it is vital to understand these fundamental relationships and correlations, as they can be powerful tools during the analysis process. However, any consistently profitable trader also understands that all markets are in a constant state of evolution and while it pays to be strict with your rules and plan, it also pays to be aware that not every strategy works every single time. Things change from time to time, and the key to being prepared for these instances is to be flexible enough to stay in the game until "normality" resumes. Let me explain further...
Figure 1 Above is a chart of three major currency pairs, EURUSD in green, GBPUSD in blue and AUDUSD in red. As we can see from late July and through August of 2008, all three pairs were following each other in a strong Supply driven downtrend, illustrating clear dollar strength. This is a common scenario in the Forex markets because when we are trading a currency, we are really trading a country and its economy. Now more than ever, as highlighted by the international Credit Crisis, we live in a world dominated by Globalization. All major world economies are linked together in some fashion, with the effects of one nation's economic bust or boom having a rippling effect on another's. This relationship often illustrates itself in the Forex markets and it is not unusual to see such currency pairs as the ones I have listed, moving in tandem. Being mindful of these relationships is a powerful tool to use on occasions, however just like any other analysis technique, it doesn't work all the time! Below is chart of the same three currency pairs but the picture is a little different.
Figure 2 We can now see that after following suit in a combined downtrend earlier in the year, there are now some differences in the patterns of behavior. In mid-December of 2008, EURUSD and GBPUSD both reached a key area of Supply or Resistance and began to sell off. AUDUSD, on the other hand, found its key Supply area a little later in early Jan 2009 before all three pairs resumed a synchronized downtrend later that month. It would have been a costly mistake to have been short on all three pairs at the same time during this period, even though they were moving together in prior months. Did the correlation resume? Fast forward to the Spring of 2009, where we can now observe a strong Demand driven uptrend on all three currency pairs.
Figure 3 When the Stock Market rebounded from its March lows, the Forex markets saw a new selloff for the US Dollar, as the Flight to Quality unwound and cash found a new home in the Equity Markets. This new-found confidence in the Broad Market had a rippling effect on worldwide economies and the power of Globalization lifted its head high once more! But as I mentioned right at the start of this article, we cannot assume that these correlations will last forever and "Why?" I hear you ask? Well the answer is pretty simple...it all comes back to individuality, a topic I talked about in my last newsletter.
You see, herd mentality is part of everyday life and not only on a Social Level but also on a Political and Economic Level. We all like to be part of the crowd and do what everyone else is doing, as it gives a sense of security, community and confidence. Yet we are all individuals deep down and some of us like to do our own thing now and then and break from the crowd when it suits us. Is it much different where national economies are concerned? Not really. Europe, Australia, the UK and USA are all feeling the same effects of recession and recovery as their economic policies are similar in many respects, but we also need to understand that these nations all have their own individual policies, as well. This individuality can cause subtle differences at the macro-economic level. Take Australia, for example. Of course it has felt the effects of the global crunch yet here we have a nation which didn't expose itself to the credit bubble as far as others did. This country also benefits from its production of Gold and other Commodities, which as we know are still being used in China. As previously stated, the consistent trader recognizes and understands these relationships but doesn't rely on them solely for picking their trades, as they objectively understand that while we are all part of a bigger picture, we are all individual at the same time.
This brings us to now: At the time of writing this article, I took a screenshot of our three currency pairs once more and we can see some very interesting things. During the middle of August, GBPUSD was finding Supply, while at the same time EURUSD and AUDUSD were finding Demand, before all three once again resumed an uptrend at the start of this month. Now, they have spilt opinions again where we can see EURUSD and AUDUSD making Highs, while GBPUSD is making Lows: We are witnessing a constant state of evolution or confusion!
Figure 4 So what can we learn from this? Whenever I am teaching a class or doing an XLT session, I always try to drill into my students that one of the key aspects of successful trading is to keep things simple. As I stated before, be aware of inter-market relationships but always be objective in the analytical process. Treat each instrument as an individual market. There is no leading indicator or correlation – everything works until it doesn't. Trading is not that different to real life. You can have an amazing group of friends or the most well-suited partner with whom you enjoy a variety of common interests and pastimes, but we have to also remember that we are still individuals and while we may share 90% of common interests, we also need time to be ourselves and do the things we alone enjoy. It may be a great relationship but it's also important to recognize that the relationship will have a greater chance of lasting if we also allow ourselves a little timeout now and then to do our thing. Is it much different in the Forex markets? I'll let you decide that one for yourself...
Have a great week and take care,
Sam Evans sevans@tradingacademy.com
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