One of the aspects of the Forex market that differentiates it from other financial markets is the concept of currency pairs.
When you take an FX position, you gain exposure to two different currencies. This creates many interesting opportunities, such as the ability to exploit your view of two economies simultaneously. It can also be complicated to judge the performance of a currency in isolation.
Consider the Euro/US Dollar currency pair (EUR/USD). If it has gained strongly on the day, is it because EUR is doing well or because USD is doing poorly?
This article will look at a solution to this problem – an online indicator called a currency strength meter that has been updated to a much better version in 2017 as a part of our MetaTrader 4 Supreme Edition. This Forex meter shows which currencies are strong and which are weak, reflecting movement in the form of a matrix. By using a proper strength meter, you will have another tool in your favour that will make you a profitable trader.
There are quite a few issues with poorly coded currency strength meters. If a currency strength meter doesn't give accurate currency strength indicator values, it's of little use regardless of its other features. With outdated currency strength meter traders might, but not necessarily, experience:
Some products might even produce data that's moved away from the original concept of what currency strength actually is. Some apply smoothing filters, like moving averages. Some apply other filters, e.g., RSI and MACD. This is just a complex algorithm of indicators that might make you enter false trades and losing streak.
The real strength of currency trading comes from correlation. Correlation matrix has been coded properly, using the latest technologies, and is unlikely to cause any of the above-mentioned issues.
Over the years, Forex strength meter has naturally evolved into a correlation matrix that could also be more complex and accurate. Forex Correlation, like other correlations, is a term designated to signal correlation between two of the pairs. When two sets of data are strongly linked together, we say they have a high correlation. When pairs move in the same direction, they have a positive correlation, and when they move in the opposite direction, we observe a negative correlation between them. A perfect correlation occurs when pairs move in the same direction, which is extremely rare. We say that correlation is high when pairs move in almost the same direction.
Elimination of double exposure: Opening multiple positions with pairs that are highly correlated is not advisable as it gives rise to more exposure. Moreover, having higher exposure to a particular currency can be harmful should the analysis go wrong. For example, by going long on AUD/CHF, AUD/JPY, and EUR/JPY, a trader gives rise to double exposure if they are highly correlated. Digging deeper, the aforementioned positions bring double exposure to AUD and JPY, which can be harmful for trade should the movement go in the opposite direction from the trader's expectations. Knowing the correlation levels between different currency pairs, a trader can get the idea of how they are connected to each other and avoid double exposure to a weak currency.
Elimination of unnecessary hedging: If the correlation strength between different pairs is known in advance, a trader can avoid unnecessary hedging. For example, there is a negative correlation between EUR/USD and USD/CHF that restricts taking positions in the same direction. The reason is when you win on one trade, you are more likely to lose on another trade, whereas the volatility makes it uncertain whether the gains will surpass losses or not.
Signals high risk trades: Correlation between different currency pairs can also signal the amount of trade strategy risk. For example, if we are going long on EUR/USD and GBP/USD, and both are positively correlated pairs, it signals a possible double risk from the same position if one of the currencies is strong. It might also happen that one of the pairs is indicating a strong movement, while the other is just ranging, which signals to avoid entering trades with correlated pairs in the opposite direction. For example, if the EUR/USD is witnessing a downtrend, and the GBP/USD is ranging, a trader should avoid going long on GBP/USD, which carries a higher downside risk due to a possible USD strength.
Positively correlated pairs pairs have shown positive correlation between them, thereby, they move in a similar direction. Negatively/inversely correlated pairs tend to trade in the opposite direction from each other.
Correlations are also divided into four groups in accordance with their strength. For easy viewing, all correlations in the following table are coloured to show their strength, as is noted below:
The MetaTrader 4 platform comes with a useful selection of popular indicators built into the client terminal. You can also download independently written custom indicators.
As MetaTrader 4 is an open platform and has such a wide community of users, indicator innovations move fast. There are thousands of custom indicators available for analysing the Forex market using different algorithms.
You can search for custom indicators from within the platform. Some charge money for the full version, but some are entirely free to download, such as our award-winning MT4SE.
Whenever you consider paying for a trading aid, remember that any reputable provider will offer a free trial version, and you can even program an algorithm yourself.
We recommend you to download MetaTrader 4 Supreme Edition – an extended version of the client terminal. It includes many features; not just the currency strength meter, but also a live trading simulator to backtest strategies. It also lets you add different custom indicators and EAs you might benefit from.
Once you've downloaded your MetaTrader 4 Supreme Edition that includes our currency strength meter, you are set to go!
How to download:
Watch the video below for the full instructions how to set up your currency strength meter on your Admiral Markets' MetaTrader 4.
The chart above shows a Forex strength meter in the form of a unique correlation matrix.
The strength of each of the major currencies is indicated by colours as we noted in the above paragraph. The currencies are also listed by different colours. This allows you to see at a glance how strong or weak different currencies are.
Easy, don't you think?
In the example above:
Equally important, whether the correlation is positive and/or negative is what matters.
In the Forex market, currency units are quoted as currency pairs. The base currency – also called the transaction currency – is the first currency appearing in a currency pair quotation, followed by the second part of the quotation called the quote currency or the counter currency.
The example above shows that CAD is the strongest as it shows +91 correlation between USD/CAD and EUR/CAD (CAD is the quote currency). The weakest correlation is between EUR/GBP (GBP is quote currency) and GBP/CHF (GBP is the base currency) – -96 – which means that the simultaneous positions in this pair in the same direction are very likely to cancel each other out, indicating the GBP strength.
Some currency meters may also provide trading signals, alongside Forex currency strength. The given example combines currency strength with a momentum-style measurement to indicate buy and sell signals for a wide number of pairs.
It shows a green up-arrow when the first (base) currency is strong and the second (counter) currency, weak. A red down-arrow denotes that the base currency is weak and the counter currency, strong.
This allows you to identify which pair has the potential to move in a certain direction.
A Forex currency meter looks at all the common currency pairs and evaluates the strength/weakness level for each individual major currency, in real time. It takes into account both the base and quote currencies.
Positive Green: Little or no correlation. Positions on these symbols will tend to move independently and have profitability, which is not related to each other.
Negative Green: Little or no correlation. Positions on these symbols will tend to move independently and have profitability, which is not related to each other.
Positive Blue (up to +30): Weak correlation. Positions on these symbols will tend to move independently and have profitability, which is not related to each other.
Positive Blue (up to +49): There may be similarity between positions on these symbols. Positions in the same direction may have similar profit. Positions in the opposite direction may offset each other.
Negative Blue (up to -30): Weak correlation. Positions on these symbols will tend to move independently and have profitability, which is not related to each other.
Negative Blue (up to -49): There may be similarity between positions on these symbols. Positions in the same direction may offset each other. Positions in the opposite direction may have similar profit.
Positive Orange (up to +75): Medium positive correlation. Positions in the same direction on these symbols will tend to have similar profit. Positions in the opposite direction will tend to cancel each other out.
Negative Orange: (up to -75): Medium negative correlation. Positions in the same direction on these symbols will tend to cancel each other out. Positions in the opposite direction will tend to have similar profit.
Positive Red: (up to +100): Strong positive correlation. Positions in the same direction on these symbols are very likely to have similar profit. Positions in the opposite direction will cancel each other out.
Negative Red: (up to -100): Strong negative correlation. Positions in the same direction on these symbols are very likely to cancel each other out. Positions in the opposite direction will have similar profit.
It's a relatively simple concept that allows you to judge the raw strength of a currency in isolation, as opposed to seeing what it is doing against another currency.
The calculation method may vary according to which Forex meter you use. One of the best known measures of a currency in isolation is the above-mentioned base vs quote currency concept. This gauge calculates the value of all available currencies relative to each other.
These currencies are:
A less-known, but more comprehensive measure is the broad USD index, which uses a wider selection of currencies.
Both work in a similar way. They calculate the strength of the Dollar by aggregating bilateral exchange rates into a single number and applying a weighting for the currencies included.
The weighting applied for the broad index is a trade weighting, derived from trade data. Specifically, this is the share of merchandise imports in annual bilateral trade with the U.S.
Currency meters work in a similar way.
They use the exchange rates of different currency pairs to produce an aggregate, comparable strength of each currency. Simple meters may not use any weighting, while more advanced ones may apply their own weightings. They may even combine other indicators with the currency strength measurement, to provide trading signals.
In terms of our correlation matrix – true strength currency meter uses complex algorithms, but is very easy to use. It even allows you to choose a strength for a certain period of time. For intraday trading, we recommend up to 200 bars, while for scalping, up to 50 bars should be enough.
Scalping: M5, 50 bars
Intraday trading: H1, 200 bars
Intra week swing trading: H1, 500 bars or H4, 200 bars
You typically use an FX strength meter as a short-term indicator. It is useful as a quick guide to which currencies are on the rise, but it's more of a snapshot than anything else.
A major advantage of the Forex strength meter is how simple it is to understand. This is especially appealing to the novice trader. You don't need to be a Forex market expert because you can just look at a simple graphical representation and see which currencies are faring well or badly.
There are weaknesses as well, though.
The indicator only communicates a very narrow piece of information. Therefore, it is worth considering how currency strength and weakness fit into the bigger picture.
Are there fundamental reasons that support the currency meter's story? Does the currency meter tell the story like other indicators? Will the trend continue?
You may find the utility of a currency strength meter limits itself.
Like most technical tools, it's more useful when used in conjunction with other indicators. For example, you might want to use a strength meter to complement or confirm what other signals are saying.
Source: GBP/JPY M30, Admiral Markets MT4, June 21 20:00 Platform Time
The image above shows the GBP/JPY chart, with a Relative Strength Index (RSI) indicator applied. The RSI attempts to identify when an instrument is oversold or undersold.
However, there's another slight drawback. The methodology behind standard indicators is well-known, but the precise calculations used for custom strength meters from unknown sources tend to be vague.
Still, a Forex strength meter can provide a convenient guide of how each currency is faring and supplementary info for working with more in-depth indicators.
If you do decide to try out a currency strength meter, it's a good idea to test it in a risk-free environment. Try experimenting with real-time market prices testing our free demo trading account to see how well it works for you!