In foreign exchange or conventional security markets, weighted alpha is designed to help discriminate between different instruments before applying a trading strategy. Think of it as selecting the right ingredients before executing a specific recipe. Weighted alpha allows forex traders to see which currency pairs are exhibiting meaningful trends and activity, acting much like a momentum indicator.

There are some who claim that weighted alpha cannot be applied to currency trading. They suggest that the nature of currency trading is fundamentally different than trading stocks and mutual funds. The entire concept of currency alpha is built on the assumption that there are inefficiencies in the currency market that can be exploited through risk analysis. Highly liquid and active markets such as forex could theoretically leave little or no time to executive effective alpha trading strategies.

That debate notwithstanding, the application of weighted alpha analysis would not be any different than its application in a traditional market.

Interpreting Weighted Alpha

Weighted alpha measures the performance of an instrument (typically a stock or mutual fund) over a course of time, except that it emphasizes recent activity over less recent activity. It's a technique for measuring price changes in one asset and comparing it to price changes in similar assets. Weighted alpha is a popular tool for preliminary trend and momentum analysis.

Tools such as forex momentum apply weighted alpha to spot the strongest current forex contracts. Contracts that have risen over the past year have positive weighted alpha scores. Traders can use this information to select which currency pairs have the most potential before applying a more thorough strategy. For example, if the NZD/USD pair has been a stronger contract than the USD/CNY, weighted alpha quantifies this strength so that traders can make an apples-to-apples comparison before exiting or entering any positions.

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