The fact that currency trading is conducted using currency pairs can make it very intimidating and confusing for inexperienced traders. Understanding how to evaluate both currencies involved in a particular trade, as well as how those currencies relate to the rest of the world’s currencies, can be a seemingly overwhelming task at times.
Understanding how one single currency is being valued by the market is the key to building a system that has an edge trading different currency pairs. Nathan Tucci from Winner’s Edge Trading wrote a post recently that illustrates this point using a comparison to horse racing. He argues that the best way to develop an edge is to trade individual currencies, not pairs.
He starts by explaining how currency pairs trading can confuse traders:
The linking of currencies in pairs can be the undoing of new traders who stop right there and think in terms of trading pairs, rather than learning that the key to trading lies in knowing that currency strength (or weakness) is calculated in relationship to another currency.
And it’s in determining the relative currency strength or weakness of an individual currency which will help you decide what your trade should be.
He discusses how to break down a currency pair for analysis:
When you view the EURUSD pair you should see that as two individual currencies.
Your task then, is to decide which currency you are going to trade within that pair.
And in order to do this you need to examine that specific currency in relationship to all other currencies in the market (at least the major ones) to determine its relative strength or weakness.
He continues to explain this concept by comparing forex trading to horse racing:
In any given horse race there is often a horse that is the favorite to win.
And sometimes there is a horse that given the right circumstances, say, a wet track, has the strong possibility of beating the odds on favorite – who never does his best on a wet track.
While this information could be helpful, Nathan explains that we also need to understand the other variables involved:
But a more informed bettor, just like a more informed forex trader, would understand that you can’t determine the best horse to win, unless you know about the other horses’ traits as well.
You need to use knowledge of all those other horses (currencies), their strengths and weaknesses, to really make the strongest betting decision.
Whether we are talking about horses or currencies, it is best to understand each variable in the field:
There are a lot of horses (like currencies) to look at if you’re going to make your best decision.
If you keep your eyes only on the top two horses and see them as a pair, you’re missing most of the information you need to make the best bet to win.
You need to look at how a horse performs against every other horse it has run against.
Just because two currencies are generally talked about together does not make them the best trade for your system to take:
Yes, those “top” two horses might be talked about together all the time (like the EURUSD pair), but it is only by looking at one horse, and then in comparing that horse to all the other horses and factors (the wet track, the starting position) that you can make the decision that is more likely to get you to the winner’s circle.