The overall forex market generally trends
more than the overall stock market. Why? The equity market, which is
really a market of many individual stocks, is governed by the micro
dynamics of particular companies. The forex market, on the other hand,
is driven by macroeconomic
trends that can sometimes take years to play out. These trends best
manifest themselves through the major pairs and the commodity block
currencies. Here we take a look at these trends, examining where and why
they occur. Then we also look at what types of pairs offer the best
opportunities for range-bound trading. (Trade 10 of the most popular currency pairs on our NEW forex trading simulator, FXtrader.)
The Majors
There are only four major currency pairs in forex, which makes it a quite easy to follow the market. They are:
The Swiss franc, on the other hand, takes its place amongst the four majors because of Switzerland's famed neutrality and fiscal prudence. At one time the Swiss franc was 40% backed by gold, but to many traders in the forex market it is still known as "liquid gold". In times of turmoil or economic stagflation, traders turn to the Swiss franc as a safe-haven currency.
The largest major pair - in fact the single most liquid financial instrument in the world - is the EUR/USD. This pair trades almost $1 trillion per day of notional value from Tokyo to London to New York 24 hours a day, five days a week. The two currencies represent the two largest economic entities in the world: the U.S. with an annual GDP of $11 trillion and the Eurozone with a GDP of about $10.5 trillion.
Although U.S. economic growth has been far better than that of the Eurozone (3.1% vs.1.6%), the Eurozone economy generates net trade surpluses while the U.S. runs chronic trade deficits. The superior balance-sheet position of the Eurozone and the sheer size of the Eurozone economy has made the euro an attractive alternative reserve currency to the dollar. As such, many central banks including Russia, Brazil and South Korea have diversified some of their reserves into euro. Clearly this diversification process has taken time as do many of the events or shifts that affect the forex market. That is why one of the key attributes of successful trend trading in forex is a longer-term outlook.
Observing the Significance of the Long Term
To see the importance of this longer-term outlook, take a look at Figure 1 and Figure 2, which both use a three-simple-moving-average (three-SMA) filter.
The
three-SMA filter is a good way to gauge the strength of trend. The
basic premise of this filter is that if the short-term trend (seven-day
SMA) and the intermediate-term trend (20-day SMA) and the long-term
trend (65-day SMA) are all aligned in one direction, then the trend is
strong.
Some traders may wonder why we use the 65 SMA. The truthful answer is that we picked up this idea from John Carter, a futures trader and educator, as these were the values he used. But the importance of the three-SMA filter not does lie in the specific SMA values, but rather in the interplay of the short-, intermediate- and long-term price trends provided by the SMAs. As long you use reasonable proxies for each of these trends, the three-SMA filter will provide valuable analysis.
Looking at the EUR/USD from two time perspectives, we can see how different the trend signals can be. Figure 1 displays the daily price action for the months of March, April and May 2005, which shows choppy movement with a clear bearish bias. Figure 2, however, charts the weekly data for all of 2003, 2004 and 2005, and paints a very different picture. According to Figure 2, EUR/USD remains in a clear uptrend despite some very sharp corrections along the way.
Warren Buffett, the famous investor who is well known
for making long-term trend trades, has been heavily criticized for
holding onto his massive long EUR/USD position which has suffered some
losses along the way. By looking at the formation on Figure 2, however,
it becomes much clearer why Buffet may have the last laugh.
Commodity Block Currencies
The three most liquid commodity currencies in forex markets are USD/CAD, AUD/USD and NZD/USD. The Canadian dollar is affectionately known as the "loonie", the Australian dollar as the "Aussie" and the New Zealand Dollar as the "kiwi". These three nations are tremendous exporters of commodities and often trend very strongly in concert with the demand for each their primary export commodity.
For instance, take a look at Figure 3, which shows the relationship between the Canadian dollar and prices of crude oil. Canada is the largest exporter of oil to U.S. and almost 10% of Canada's GDP comprises the energy exploration sector. The USD/CAD trades inversely, so Canadian dollar strength creates a downtrend in the pair.
Although Australia
does not have many oil reserves, the country is a very rich source of
precious metals and is the second-largest exporter of gold in the world.
In Figure 4 we can see the relationship between the Australian dollar
and gold.
Crosses Are Best for Range
In contrast to the majors and commodity block currencies, both of which offer traders the strongest and longest trending opportunities, currency crosses present the best range-bound trades. In forex, crosses are defined as currency pairs that do not have the USD as part of the pairing. The EUR/CHF is one such cross, and it has been known to be perhaps the best range-bound pair to trade. One of the reasons is of course that there is very little difference between the growth rates of Switzerland and the European Union. Both regions run current-account surpluses and adhere to fiscally conservative policies.
One strategy for range traders is to determine the parameters of the range for the pair, divide these parameters by a median line and simply buy below the median and sell above it. The parameters of the range is determined by the high and low between which the prices fluctuate over a give period. For example in EUR/CHF, range traders could, for the period between May 2004 to Apr 2005, establish 1.5550 as the top and 1.5050 as the bottom of the range with 1.5300 median line demarcating the buy and sell zones. (See Figure 5 below).
Remember range traders are agnostic about direction (for more on this, see Trading Trend or Range?). They simply want to sell relatively overbought conditions and buy relatively oversold conditions.
Cross currencies are so attractive for the range-bound strategy because they represent currency pairs from culturally and economically similar countries; imbalances between these currencies therefore often return to equilibrium. It is hard to fathom, for instance, that Switzerland would go into a depression while the rest of Europe merrily expands. The same sort of tendency toward equilibrium, however, cannot be said for stocks of similar nature. It is quite easy to imagine how, say, General Motors could file for bankruptcy even while Ford and Chrysler continue to do business. Because currencies represent macroeconomic forces they are not as susceptible to risks that occur on the micro level - as individual company stocks are. Currencies are therefore much safer to range trade.
Nevertheless, risk is present in all speculation, and
traders should never range trade any pair without a stop loss. A
reasonable strategy is to employ a stop at half the amplitude of the
total range. In the case of the EUR/CHF range we defined in Figure 5,
the stop would be at 250 pips above the high and 250 below the low. In
other words if this pair reached 1.5800 or 1.4800, the trader should
stop him- or herself out of the trade because the range would most
likely have been broken.
Interest Rates - the Final Piece of the Puzzle
While EUR/CHF has a relatively tight range of 500 pips over the year shown in Figure 5, a pair like GBP/JPY has a far larger range at 1800 pips, which is shown in Figure 6. Interest rates are the reason there's a difference.
The interest rate differential between two countries affects the trading range of their currency pairs. For the period represented in Figure 5, Switzerland has an interest rate of 75 basis points (bps) and Eurozone rates are 200 bps, creating a differential of only 125 bps. However, for the period represented in Figure 6, however, the interest rates in the U.K are at 475 bps while in Japan - which is gripped by deflation - rates are 0 bps, making a whopping 475 bps differential between the two countries. The rule of thumb in forex is the larger the interest rate differential, the more volatile the pair.
To
further demonstrate the relationship between trading ranges and
interest rates, the following is a table of various crosses, their
interest rate differentials and the maximum pip movement from high to
low over the period from May 2004 to May 2005.
While
the relationship is not perfect, it is certainly substantial. Note how
pairs with wider interest rate spreads typically trade in larger ranges.
Therefore, when contemplating range trading strategies in forex,
traders must be keenly aware of rate differentials and adjust for
volatility accordingly. Failure to take interest rate differential into
account could turn potentially profitable range ideas into losing
propositions.
The forex market is incredibly flexible, accommodating both trend and range traders, but as with success in any enterprise, proper knowledge is key.
The Majors
There are only four major currency pairs in forex, which makes it a quite easy to follow the market. They are:
- EUR/USD - euro / U.S. dollar
- USD/JPY - U.S. dollar / Japanese yen
- GBP/USD - British pound / U.S. dollar
- USD/CHF - U.S. dollar / Swiss franc
The Swiss franc, on the other hand, takes its place amongst the four majors because of Switzerland's famed neutrality and fiscal prudence. At one time the Swiss franc was 40% backed by gold, but to many traders in the forex market it is still known as "liquid gold". In times of turmoil or economic stagflation, traders turn to the Swiss franc as a safe-haven currency.
The largest major pair - in fact the single most liquid financial instrument in the world - is the EUR/USD. This pair trades almost $1 trillion per day of notional value from Tokyo to London to New York 24 hours a day, five days a week. The two currencies represent the two largest economic entities in the world: the U.S. with an annual GDP of $11 trillion and the Eurozone with a GDP of about $10.5 trillion.
Although U.S. economic growth has been far better than that of the Eurozone (3.1% vs.1.6%), the Eurozone economy generates net trade surpluses while the U.S. runs chronic trade deficits. The superior balance-sheet position of the Eurozone and the sheer size of the Eurozone economy has made the euro an attractive alternative reserve currency to the dollar. As such, many central banks including Russia, Brazil and South Korea have diversified some of their reserves into euro. Clearly this diversification process has taken time as do many of the events or shifts that affect the forex market. That is why one of the key attributes of successful trend trading in forex is a longer-term outlook.
Observing the Significance of the Long Term
To see the importance of this longer-term outlook, take a look at Figure 1 and Figure 2, which both use a three-simple-moving-average (three-SMA) filter.
 Figure
1: Charts the EUR/USD exchange rate from Mar 1 to May 15, 2005. Note
recent price action suggests choppiness and a possible start of a
downtrend as all three simple moving averages line up under one another.
|
 Figure
2: Charts the EUR/USD exchange rate from Aug 2002 to Jun 2005. Every
bar corresponds to one week rather than one day (as in Figure 1). And in
this longer-term chart, a completely different view emerges - the
uptrend remains intact with every down move doing nothing more than
providing the starting point for new highs. |
Some traders may wonder why we use the 65 SMA. The truthful answer is that we picked up this idea from John Carter, a futures trader and educator, as these were the values he used. But the importance of the three-SMA filter not does lie in the specific SMA values, but rather in the interplay of the short-, intermediate- and long-term price trends provided by the SMAs. As long you use reasonable proxies for each of these trends, the three-SMA filter will provide valuable analysis.
Looking at the EUR/USD from two time perspectives, we can see how different the trend signals can be. Figure 1 displays the daily price action for the months of March, April and May 2005, which shows choppy movement with a clear bearish bias. Figure 2, however, charts the weekly data for all of 2003, 2004 and 2005, and paints a very different picture. According to Figure 2, EUR/USD remains in a clear uptrend despite some very sharp corrections along the way.
Commodity Block Currencies
The three most liquid commodity currencies in forex markets are USD/CAD, AUD/USD and NZD/USD. The Canadian dollar is affectionately known as the "loonie", the Australian dollar as the "Aussie" and the New Zealand Dollar as the "kiwi". These three nations are tremendous exporters of commodities and often trend very strongly in concert with the demand for each their primary export commodity.
For instance, take a look at Figure 3, which shows the relationship between the Canadian dollar and prices of crude oil. Canada is the largest exporter of oil to U.S. and almost 10% of Canada's GDP comprises the energy exploration sector. The USD/CAD trades inversely, so Canadian dollar strength creates a downtrend in the pair.
 Figure
3: This chart displaysthe relationship between the loonie and price of
crude oil. The Canadian economy is a very rich source of oil reserves.
The chart shows that as the price of oil increases, it becomes less
expensive for a person holding the Canadian dollar to purchase
U.S.dollars. |
 Figure
4: This chart looks at the relationship between the Aussie and gold
prices (in U.S. dollars). Note how a rally in gold from Dec 2002 to Nov
2004 coincided with a very strong uptrend in the Australian dollar. |
Crosses Are Best for Range
In contrast to the majors and commodity block currencies, both of which offer traders the strongest and longest trending opportunities, currency crosses present the best range-bound trades. In forex, crosses are defined as currency pairs that do not have the USD as part of the pairing. The EUR/CHF is one such cross, and it has been known to be perhaps the best range-bound pair to trade. One of the reasons is of course that there is very little difference between the growth rates of Switzerland and the European Union. Both regions run current-account surpluses and adhere to fiscally conservative policies.
One strategy for range traders is to determine the parameters of the range for the pair, divide these parameters by a median line and simply buy below the median and sell above it. The parameters of the range is determined by the high and low between which the prices fluctuate over a give period. For example in EUR/CHF, range traders could, for the period between May 2004 to Apr 2005, establish 1.5550 as the top and 1.5050 as the bottom of the range with 1.5300 median line demarcating the buy and sell zones. (See Figure 5 below).
 Figure
5: This charts the EUR/CHF (from May 2004 to Apr 2005), with 1.5550 as
the top and 1.5050 as the bottom of the range, and 1.5300 as the median
line. One range-trading strategy involves selling above the median and
buying below the median. |
Cross currencies are so attractive for the range-bound strategy because they represent currency pairs from culturally and economically similar countries; imbalances between these currencies therefore often return to equilibrium. It is hard to fathom, for instance, that Switzerland would go into a depression while the rest of Europe merrily expands. The same sort of tendency toward equilibrium, however, cannot be said for stocks of similar nature. It is quite easy to imagine how, say, General Motors could file for bankruptcy even while Ford and Chrysler continue to do business. Because currencies represent macroeconomic forces they are not as susceptible to risks that occur on the micro level - as individual company stocks are. Currencies are therefore much safer to range trade.
Interest Rates - the Final Piece of the Puzzle
While EUR/CHF has a relatively tight range of 500 pips over the year shown in Figure 5, a pair like GBP/JPY has a far larger range at 1800 pips, which is shown in Figure 6. Interest rates are the reason there's a difference.
The interest rate differential between two countries affects the trading range of their currency pairs. For the period represented in Figure 5, Switzerland has an interest rate of 75 basis points (bps) and Eurozone rates are 200 bps, creating a differential of only 125 bps. However, for the period represented in Figure 6, however, the interest rates in the U.K are at 475 bps while in Japan - which is gripped by deflation - rates are 0 bps, making a whopping 475 bps differential between the two countries. The rule of thumb in forex is the larger the interest rate differential, the more volatile the pair.
 Figure 6: This charts the GBP/JPY (from Dec 2003 to Nov 2004). Notice the range in this pair is almost 1800 pips! |
| Currency Pair | Central Bank Rates (in basis points) | Interest Rate Spread (in basis points) | 12-Month TradingRange (in pips) |
| AUD/JPY | AUD - 550 / JPY - 0 | 550 | 1000 |
| GBP/JPY | GBP - 475 / JPY - 0 | 475 | 1600 |
| GBP/CHF | GBP - 475 / CHF - 75 | 400 | 1950 |
| EUR/GBP | EUR - 200 / GBP - 475 | 275 | 550 |
| EUR/JPY | EUR - 200 / JPY - 0 | 200 | 1150 |
| EUR/CHF | EUR - 200 / CHF - 75 | 125 | 603 |
| CHF/JPY | CHF - 75 / JPY - 0 | 75 | 650 |
The forex market is incredibly flexible, accommodating both trend and range traders, but as with success in any enterprise, proper knowledge is key.
