Every currency pair has qualities unique to it. Find out what those qualities are.
Much has been written about the suitability of technical analysis for trading in the currency markets. While this is undoubtedly true, it can leave traders, particularly those new to the currency markets, with the impression that all technical tools are equally applicable to all major currency pairs. However, anyone who has traded Forex for any length of time will recognise that, for example, dollar/Yen (USD/JPY) and dollar/Swiss (USD/CHF) trade-in distinctly different fashions.
Why, then, should a one-size-fits-all technical approach be expected to produce steady trading results? Instead, traders are more likely to experience improved results if they recognise the differences between the major currency pairs and employ different technical strategies to them. This article will explore some of the differences between the major currency pairs and suggest technical approaches that are best suited to each pair’s behavioral tendencies.
By far the most actively traded currency pair is euro/dollar (EUR/USD), accounting for 28 percent of daily global volume in the most recent Bank for International Settlements (BIS) survey of currency market activity. EUR/USD receives further interest from volume generated by the Euro-crosses (e.g. euro/British pound (EUR/GBP), EUR/CHF and EUR/JPY, and this interest tend to be contrary to the underlying U.S. dollar direction. For example, in a U.S. dollar-negative environment, the Euro will have an underlying bid stemming from overall U.S. dollar selling. However, less liquid dollar pairs (e.g. USD/CHF) will be sold through the more liquid Euro crosses, in this case resulting in EUR/CHF selling, which introduces a Euro offer into the EUR/USD market.
This two-way interest tends to slow Euro movements relative to other major dollar pairs and makes it an attractive market for short-term traders, who can exploit “backing and filling.” On the other hand, this depth of liquidity also means EUR/USD tends to experience prolonged, seemingly inconclusive tests of technical levels, whether generated by trendline analysis or Fibonacci/Elliott wave calculations. This suggests breakout traders need to allow for a greater margin of error: 20-30 pips. (A pip is the smallest increment in which a foreign currency can trade with respect to identifying breaks of technical levels.) Another way to gauge whether EUR/USD is breaking out is to look to the less liquid USD/CHF and GBP/USD. If these pairs have broken equivalent technical levels, for example, recent daily highs, then EUR/USD is likely to do the same after a lag. If “Swissy” and “Cable” (the popular name for British pound) are stalling at those levels, then EUR/USD will likely fail as well.
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In terms of technical studies, the overwhelming depth of EUR/USD suggests that momentum oscillators are well-suited to trading the euro, but traders should consider adjusting the studies’ parameters (increase time periods) to account for the relatively plodding, back-and-fill movements of EUR/USD.
In this sense, reliance on very short-term indicators (less than 30 minutes) exposes traders to an increased likelihood of “whipsaw” movements. Moving average convergence divergence (MACD) is a momentum study is well-suited to EUR/USD, particularly because it utilises exponential moving averages (greater weight to more recent prices, less to old prices) in conjunction with a third moving average, resulting in fewer false crossovers. Short-term (hourly) momentum divergences routinely occur in EUR/USD, but they need to be confirmed by breaks of price levels identified through trendline analysis to suggest an actionable trade. When larger moves are underway, traders are also likely to find the directional movement indicator (DMI) system useful for confirming whether a trend is in place, in which case momentum readings should be discounted, and might choose to rely on DI+/DI- crossovers for additional trade entry signals.
The next most actively traded currency pair is USD/JPY, which accounted for 17 percent of daily global volume in the 2004 BIS survey of currency market turnover. USD/JPY has traditionally been the most politically sensitive currency pair, with successive U.S. governments using the exchange rate as a lever in trade negotiations with Japan. While China has recently replaced Japan as the Asian market evoking U.S. trade tensions, USD/JPY still acts as a regional currency proxy for China and other less-liquid, highly regulated Asian currencies. In this sense, USD/JPY is frequently prone to extended trending periods as trade or regional political themes (e.g. yuan revaluation) play out.
For day-to-day trading, however, the most significant feature of USD/JPY is the heavy influence exerted by Japanese institutional investors and asset managers. Due to a culture of intra-Japanese collegiality, including extensive position and strategy information-sharing, Japanese asset managers frequently act in the same direction on the yen in the currency market. In concrete terms, this frequently manifests itself in clusters of orders at a similar price or technical levels, which then reinforce those levels as points of support or resistance. Once these levels are breached, similar clusters of stop loss orders are frequently just behind, which in turn fuel the breakout.
An alternate tactic frequently employed by Japanese asset managers is to stagger orders to take advantage of any short-term reversals in the direction of the larger trend. For example, if USD/JPY is at 115.00 and trending higher, USD/JPY buying orders would be placed at arbitrary price points, such as 114.75, 114.50, 114.25 and 114.00, to take advantage of any pullback in the broader trend. This also helps explain why USD/JPY frequently encounters support or resistance at numerically round levels, even though there may be no other corresponding technical significance.
Take A Look at Trendlines
Turning to the technical side of USD/JPY, the foregoing discussion suggests trendline analysis as perhaps the most significant technical tool for trading USD/JPY. USD/JPY tends to experience fewer false breaks of trendlines because of the clustering of Japanese institutional orders around technical or price levels. Short-term trendlines, such as hourly or 15 minutes, can be used effectively, but traders need to operate on a similarly short-term basis; daily closing levels hold the most meaning in USD/JPY.
In terms of chart analysis, Japanese institutional asset managers rely heavily on candlestick charts (which depend heavily on daily close levels) and traders would be well-advised to learn to recognise major candlestick patterns, such as Doji, hanging man, tweezer tops/bottoms and the like.
Momentum oscillators such as the relative strength index (RSI), MACD or stochastics should generally be avoided, especially intraday, due to the trending and institutional nature driving USD/JPY. While a momentum indicator may reverse course, typically suggesting a potential trade, price action often fails to reverse enough to make the trade worthwhile due to underlying institutional interest.
Finally, Ichimoku analysis (roughly translated as a one-glance cloud chart) is another largely Japanese-specific trend identification system that highlights trends and major reversals.
A Look At Some Illiquid Currencies
Two of the least liquid major currency pairs:
The so-called Swissy holds a place among the major currency pairs due to Switzerland’s unique status as a global investment haven. USD/CHF trades mostly based on overall U.S. dollar sentiment, as opposed to Swiss-based economic fundamentals.
Liquidity in USD/CHF is never very good. The lower liquidity and higher volatility of Swissy also make it a significant leading indicator for major U.S. dollar movements. Swissy will also lead the way in shorter-term movements, but the overall volatility and general jitteriness of USD/CHF price action make false breaks of technical levels common.
Cable (GBP/USD), or sterling, also suffers from relatively poor liquidity and this is in part due to its higher pip value (U.S. dollars) and the relatively Euro-centric basis of U.K. trade. The cable also react sharply to U.K. fundamental data as well as to U.S. news. Sterling’s price action will also display extreme one-way tendencies during larger moves, as traders caught on the wrong side chase the illiquid market to the extremes.
Focus On Risk Management
The volatility and illiquidity of Swissy and sterling suggest traders need to use a more proactive overall approach to trading these pairs, particularly concerning risk management (i.e. position size in relation to stop levels). With regard to technical tools, the tendency for both pairs to make short-term false breaks of chart levels suggests breakout traders need to be particularly disciplined concerning stop entry levels. In this sense, trendline analysis of periods less than an hour tends to generate more noise than tradable breakpoints, so a focus on longer time periods (four hours-daily) is likely to be more successful in identifying meaningful breaks. By the same token, once a breakout occurs, surpassing the margin of error, the ensuing one-way price action favors traders who are quick on the trigger, and this suggests employing resting stop-loss entry orders to reduce slippage.
The volatility inherent in Cable and Swissy makes the use of short-term (hourly and shorter) momentum oscillators problematic, due to both false crossovers and divergences between price/momentum that frequently occur in these time frames. Longer-period oscillators (four hours and more) are best used to highlight potential reversals or divergent price action. Instead, momentum signals need to be confirmed by other indicators, such as breaks of trendlines, Fibonacci retracements or parabolic levels, before a trade is initiated.
It’s Not One Size Fits All
Traders who seek to apply technical trading approaches to the currency market should be aware of the differences in the trading characteristics of the major currency pairs. Just because the euro and the pound are both traded against the dollar does not mean they will trade identically to each other. A more thorough understanding of the various market traits of currencies suggests that certain technical tools are better suited to some currency pairs than others. A currency-specific approach to applying technical analysis is more likely to produce successful results than a one-size-fits-all application across all currency pairs.