Trading Rules - Always Pair Strong With Weak
Every baseball fan has a favorite team. The true fan knows who the team can easily beat, who they will probably lose against and who poses a big challenge. Placing a gentleman's bet on the game, the baseball fan knows the best chance for success occurs against a much weaker opponent. Although we are talking about baseball, the logic holds true for any contest. When a strong army is positioned against a weak army, the odds are heavily skewed toward the strong army winning. This is the way you should approach trading.
Matching Up Currency Pairs
When we trade currencies, we are always dealing in pairs - every trade involves buying one currency and shorting another. So, the implicit bet is that one currency will beat out the other. If this is the way the FX market is structured, then the highest probability trade will be to pair a strong currency with a weak currency. Fortunately, in the currency market, we deal with countries whose economic outlooks do not change instantaneously. Economic data from the most actively traded currencies are released every single day, which acts as a scorecard for each country. The more positive the reports, the better or stronger a country is doing; on the flip side, the more negative the reports, the weaker the country's performance. (To get a better idea of the available economic data, look at Economic Indicators.)
Pairing a strong currency with a weak currency has much deeper ramifications than just the data itself. Each strong report gives a better reason for the central bank to increase interest rates, which increases the currency's yield. In contrast, the weaker the economic data, the less flexibility a country's central bank has in raising interest rates, and in some instances, if the data comes in extremely weak, the central bank may even consider lowering interest rates. The future path of interest rates is one of the biggest drivers of the currency market because it increases the yield and attractiveness of a country's currency. (For more insight, see Get To Know The Major Central Banks.)
Using Interest Rates
In addition to looking at how data is stacking up, an easier way to pair strong with weak may be to compare the current interest rate trajectory for a currency. For example, EUR/GBP (which is traditionally a very range-bound currency pair) broke out in the first quarter of 2006. The breakout occurred to the upside because Europe was just beginning to raise interest rates as economic growth improved.
The sharp contrasts in what each country was doing with interest rates forced the EUR/GBP materially higher and even turned the traditionally range-bound EUR/GBP into a mildly trending currency pair for a few months. The shift was easily anticipated, making EUR/GBP a clear trade based on pairing a strong currency with a weak currency. Because strength and weakness can last for some time as economic trends evolve, pairing the strong with the weak currency is one of the best ways for traders to gain an edge in the currency market. (To find out more, see Forces Behind Exchange Rates.)