by Boris Schlossberg and Kathy Lien

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.)



Being Right but Being Early Simply Means That You Are Wrong

Related Articles
  1. Trading

    Drastic Currency Changes: What's The Cause?

    Currency fluctuations often defy logic. Learn the trends and factors that result in these movements.
  2. Trading

    What Makes the EUR/USD A Risky Trade Now?

    What are the current risks of trading the EUR/USD pair? The Fed may raise interest rates this summer and the ECB has begun a quanitative easing program.
  3. Trading

    Range Trade Forex With Non-U.S. Dollar Pairs

    If you are following a range-trading strategy, you're better off with pairs that do not include the U.S. dollar. Find out why.
  4. Trading

    Currency Carry Trades 101

    This strategy can provide returns even if the currency pair doesn't move a cent.
  5. Trading

    Popular Forex Currencies

    Learn about the most traded currencies and the strategies used to trade them.
  6. Investing

    Why Countries Keep Reserve Currency

    Central banks and financial institutions hold large amounts of foreign money as their reserve currency.
  7. Trading

    4 Of The Most Popular Traded Currencies

    Every day, trillions of dollars trade in the forex market. Here are a few of the most popular currencies, and some characteristics for each.
  8. Trading

    8 Basic Forex Market Concepts

    We go over some of the things you need to understand before you can trade currencies.
Frequently Asked Questions
  1. How do you calculate r-squared in Excel?

    Calculate R-squared in Microsoft Excel by creating two data ranges to correlate. Use the Correlation formula to correlate ...
  2. What is the Difference Between International Monetary Fund and the World Bank?

    Learn about the International Monetary Fund and the World Bank and how they are differentiated by their respective functions ...
  3. Where Did the Bull and Bear Market Get Their Names?

    The terms bull and bear are used to describe general actions and attitudes, or sentiment, either of an individual (bear and ...
  4. What's the difference between Google's GOOG and GOOGL stock tickers?

    Learn the difference between Google's GOOG and GOOGL ticker symbols. Splitting shares into classes prevents management from ...
Trading Center