How to Trade Using a Forex Currency Strength Meter
Reading time: 15 minutes
One of the aspects of the Forex (FX) 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. However, It can also be quite complicated to judge the performance of a currency in isolation. Consider the Euro/US Dollar currency pair (EURUSD).
If it has gained strongly on the day, is it because the EUR is doing well? or because the USD is performing poorly? This article will look at a solution to this problem – an online indicator referred to as a 'Currency Strength Meter'. This Forex meter displays which currencies are strong and which are weak at any given moment, reflecting movement in the form of a matrix. By using an effective daily strength meter, you will have another tool at your disposal that will enable you to potentially become a profitable trader.
The Difference Between the Currency Strength Meter and the Correlation Matrix
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 With outdated currency strength meters, traders might, but not necessarily, experience:
- MetaTrader 4 (MT4) freezes
- PC freezes
- Whipsaw signals
- Memory leakage
- CPU working constantly at 100 %.
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, while 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 potentially enter a losing streak. The real strength of currency trading comes from correlation. If the Correlation Matrix has been coded properly, using the latest technologies, it is unlikely to cause any of the aforementioned issues.
Forex Correlation Matrix – The Real Currency Strength Meter
Over the years, the 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 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 that they have a negative correlation. 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.
The Advantages of Using the Real Currency Strength Meter
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 AUDCHF, AUDJPY, and EURJPY, 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 an idea of how they are connected to each other, and may consequently 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, if there is a negative correlation between EUR/USD and USD/CHF, this restricts the ability to take positions in the same direction. The reason is that when you win on one trade, you are more likely to lose on another trade, whereas the volatility makes it uncertain as to whether or not the gains will surpass the losses or not.
Signal 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 GBPUSD, and both are positively correlated pairs, it signals a possible double risk from the same position if one of the currencies is strong. What might also happen is that one of the pairs indicates a strong movement, while the other is just ranging, which signals traders 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 possible USD strength.
Positive and Negative Correlation Signals True Currency Strength
Source: Admiral Markets MetaTrader 4 Supreme Edition - Correlation Matrix
In the example above, positively correlated pairs have shown positive correlation between them, therefore, 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 table above are coloured to show their strength, as is noted below:
- Green: Little or no correlation
- Blue: Weak correlation
- Orange: Medium correlation
- Red: Strong correlation
Additionally, if you unfamiliar with the currency pairs listed, here's a quick breakdown of what they are, together with different ways you might see them:
- EURUSD - EUR to USD - Euro to United States Dollar
- EURCHF - EUR to CHF - Euro to Swiss Franc
- GBPUSD - GBP to USD - Great British Pound to United States Dollar
- GBPJPY - GBP to JPY - Great British Pound to Japanese Yen
- GBPNZD - GBP to NZD - Great British Pound to New Zealand Dollar
- USDCAD - USD to CAD - United States Dollar to Canadian Dollar
- EURCAD - EUR to CAD - Euro to Canadian Dollar
- USDJPY - USD to JPY - United States Dollar to Japanese Yen
- GBPAUD - GBP to AUD - Great British Pound to Australian Dollar
- GBPCHF - GBP to CHF - Great British Pound to Swiss Franc
- EURGBP - EUR to GBP - Euro to Great British Pound
Downloading a Currency Strength Meter
MT4 is an extremely widespread FX trading platform. One of its advantages is the ability to download and use custom indicators, together with, Expert Advisors (EAs). The MT4 platform comes with a useful selection of popular indicators built into the client terminal. You can also download independently written custom indicators. As MT4 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 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. MT4SE is 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 allows you to add different custom indicators and EAs you might benefit from.
Forex Currency Strength Meter Basics
Source: Admiral Markets MetaTrader 4 Supreme Edition - Forex Strength Meter - Correlation Matrix
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.
In the example above, the colours refer to the following occurrences:
- Green: Little or no correlation
- Blue: Weak correlation
- Orange: Medium correlation
- Red: Strong correlation
Additionally, it is important as to whether the correlation is positive and/or negative. In the Forex market, currency units are quoted as currency pairs. The base currency – also called the transaction currency – is the first currency that appears 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 currency, as it shows a +91 correlation between USDCAD and EURCAD (CAD is the quote currency). The weakest correlation is between EURGBP (GBP is the quote currency) and GBPCHF (GBP is the base currency) – -96 – which means that the simultaneous positions in this pair within the same direction are very likely to cancel each other out, indicating GBP strength and that the Swiss Franc is the weakest currency.
Some currency meters may also provide trading signals, alongside Forex currency strength. The example above 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 is weak. A 'red down-arrow' denotes that the base currency is weak, and that the counter currency is strong. This allows you to identify which pair has the potential to move in a certain direction.
How Does the Forex Currency Strength Meter Work?
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. Here is how the correlations can be observed, according the colours achieved:
- Positive Green: Little or no correlation. Positions on these symbols will tend to move independently and have profitability, which are not related to each other.
- Negative Green: Little or no correlation. Positions on these symbols will tend to move independently and have profitability, which are 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 are 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 are 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.
As you can see, 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 aforementioned base vs quote currency concept. This gauge calculates the value of all available currencies relative to each other.
These currencies are:
- The Euro (EUR)
- The Japanese Yen (JPY)
- The British Pound (GBP)
- The Australian Dollar (AUD)
- The Canadian Dollar (CAD)
- The Swedish Krona (SEK)
- The Swiss Franc (CHF)
- The Hungarian Forint (HUF)
- The Polish Zloty (PLN)
- The Norwegian Krone (NOK)
- The Singapore Dollar (SGD)
- The Mexican Peso (MXN)
- The Russian Rouble (RUB)
A lesser 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 then 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 the Admiral Markets Correlation Matrix – the 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, it is typically recommended to use up to 200 bars, while for scalping, up to 50 bars should be enough.
- Scalping: M5 - 50 bars
- Intraday trading: H1 - 200 bars
- Intraweek swing trading: H1 - 500 bars or H4 - 200 bars
Source: Admiral Markets Correlation Matrix - MetaTrader 4 Supreme Edition
Advantages and Disadvantages of Using a Currency Strength Meter
Professional traders 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 performing inadequately. The Forex currency strength meter is arguably one of the best free currency strength indicators out there!
There are however weaknesses as well. 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 accurately 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: GBPJPY M30, Admiral Markets MT4, Accessed: June 21 20:00 2017- Platform Time - Data Range - 13 June 2017 - 24 June 2017
The image above displays the GBPJPY 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 tends to be vague.
Still, a Forex strength meter can provide a convenient guide of how each currency is faring, as well as 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 trading environment. Why not try experimenting with real-time market prices in our free Forex Demo trading account?, and see how well it works for you!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.