Hello traders! I was a bit hesitant when considering this week’s Lessons from the Pros article, because the topic is very subjective. The difficulty lies in fully explaining the possible interpretations of the following chart, and how what could be a powerful tool for you may be misinterpreted if used improperly. If you are having difficulty with the concept, perhaps bring it up in one of the Extended Learning Track rooms that you are in – it may be easier to grasp the concept when watching this happen live!
This topic concerns the relationship or relative strength of one currency pair with another. No, not one currency vs. another, which is what we usually talk about. But one currency pair vs. another. This is easily visualized by looking at two charts side by side – “they are both going up” or “one is flat and the other is trending.” But our topic this week is the actual strength of one currency pair’s trend vs. another currency pair’s, not the Relative Strength Index – this merely measures a currency pair’s strength vs. its own prior movement.
What I am referring to specifically is when you are looking at two different currency pairs, and are trying to decide on which pair to trade. Both are in uptrends (for example), and both have pulled back to qualified demand zones. Which pair to trade? Perhaps trade both? Or would you rather choose one of them? In this example, we are going to choose one of them instead of diversifying into both.
In the following chart, I have changed it from a standard price axis line to a percent change axis, and also inserted the GBPUSD into the same frame as the EURUSD. (Not every firm offers this type of chart, you may have to merely compare one price chart over another.) Here the blue line is the EURUSD, and the red line is the GBPUSD. On the minor swing low of the EURUSD of July 24, I started the calculation of future percent changes. The higher the colored lines go, the bigger their percent change is from the baseline on July 24.
Here are my notes from the chart:
- EURUSD takes off nice and strong, GBPUSD follows but not as quickly.
- Both pairs pull back, but the EURUSD doesn’t pull back as far, and then takes off much faster.
- Both pairs continue to trend higher, but the EURUSD is widening its lead vs. the GBPUSD, showing greater relative strength
- EURUSD has dramatically strengthened vs. the angle of the GBPUSD
- GBPUSD is slowly weakening, while the EURUSD is having a much sharper retracement.
- Notice the relationship between the lower lows of the GBPUSD chart, but the EURUSD is actually showing a recent higher low, more relative strength for the EURUSD. Also note the higher high of the EURUSD, but not of the GBPUSD
- EURUSD still showing relative strength vs. the GBPUSD with higher lows
So what does this mean? Over the last few weeks, percent-wise the EURUSD has shown bigger moves to the upside than the GBPUSD – a greater relative strength. Very recently the GBPUSD has been showing its relative weakness with lower highs and lower lows. So how should we use this new information? When I am considering a long trade and am going to have to choose between two currency pairs, don’t you think it would be more profitable to trade the one that is showing greater relative strength? Of course! If I was planning a short trade, do you think it would be more or less profitable to trade the currency pair showing weakness? I hope you said more profitable!
Here is an easy checklist to help with your decisions:
- What are the longer term trends in the pairs being considered? (Much easier to compare two pairs in similar trends!)
- How far “up the curve” are they? Are the pairs running into long term supply or demand? If so, you may not want to trade in the direction of the latest trend as it may be close to being over.
- Are both pairs in quality demand or supply zones?
- Compare the two pairs, using the line comparison chart. Which is showing greater relative strength if you are looking for long trades, or which is showing relative weakness when looking for short trades.
One more thing to mention. You will need to “zero out” your charts periodically. One rule could be to reset the charts whenever you have a new change in trend, or a new significant swing high or low. If you don’t reset your chart occasionally, after a few weeks or months the percent difference will be so wide both lines will barely fit on the charts!
I expect with a little practice this relative strength comparison will help you make a few more pips! Until next time,