In a previous article we hinted at “relative value” as a key concept in trading – not just in FX. However, the FX market is a great training ground for this kind of thinking and as such, today we shall uncover a way with which FX Dealers seek value in FX.
Many traders find it difficult to translate fundamental views into actionable trades, and basically give up completely on the task, preferring to stare at charts as opposed to seeking an understanding of the fundamental picture. In reality there are three separate steps that traders should take:
- forming a fundamental view
- translating that view into a trade idea (which is what we will cover today)
- waiting until the market aligns with a timing model
It’s all connected
FX is truely a great training camp, for those that are willing to put in a bit of hard work. In order to understand how an FX dealer views “the World”, you just have to keep in mind that capital flows connect everything.
So for example, let’s hypothesize we are keen on trading the Canadian Dollar. In FX, everything is relative. As such, if we were driven towards the Canadian Dollar – for some fundamental reason – we need a routine that helps us uncover the best value proposition. In FX, there are no absolutes. So you cannot be “bullish” or “bearish” on the Canadian Dollar. You need to be “bullish the Canadian Dollar against something else“.
So sure, we can definitely approach the major pair (USD/CAD) first, but in order to understand the driver, we then have to check the Dollar Index (DXY) to see whether it’s a USD move or it is “something else”.
From UsdCad to AudCad
If, after this check, USD/CAD is up 50 pips but the DXY is only up 5 pips then it’s not a USD-dynamic. At this point we might move towards AudCad for a cross-check: Cad and Aud are both commodity currencies (or “Comm-Dolls” in jargon) but there is more liquidity in AUD than CAD during the AsiaPacific session, and into the European session. If AUD/CAD is up 45 pips (vs. 50 on UsdCad), evidently the move is either CAD-cross related or AUD specific. And at that point, a cursory read of a macro calendar or a session wrap-up will most likely help identify the driver.
If that doesn’t solve the mystery, after AudCad we can double-check the commodities that influence Aud:
- iron ore
- copper
- crude oil
Now we know whether the move is generated by AUD fundamentals specifically. If we still don’t spot anything significant, it’s time to check AUD/JPY and CAD/JPY as well as AUD/NZD as that cross moves on those components overseas and by news driven out of the local centres.
If it’s AUD/JPY & CAD/JPY moving then we can check the Nikkei and general Asian stock markets on the assumption it’s a “risk on/risk off” theme.
Influences from Abroad
The process above, which we may define “hunting the drivers“, is one way to be sector specific within equity and commodity drivers and assemble a lower risk / stronger correlated AUD, CAD, JPY or NZD position.
By isolating the bigger flow influences on each individual component and constructing a cross between them that expresses your world view but removes the volatile USD component from the scenario, it becomes possible to enhance your odds and get as close as possible to “maximum efficiency“.
If we’re interested in tracking the AUD, we will need to keep tabs on:
- iron ore
- copper
- gold
- coal
- Asian stocks (Nikkei especially)
- China economic data
- Aussie Bonds
If we’re interested in tracking CAD, we will need to keep tabs on:
- Crude Oil
- natural gas
- gold
- Aluminium
- US-CAD Bond Spreads
- US equities
- CRB index
If we are interested in tracking NZD, we will need to keep tabs on:
- milk (GDT Auctions)
- beef fishery products
- Bond spreads
Over to You
Currency trading really does ehnahce your view of the world, if you train yourself correctly. Everything is connected, and there is always more than one way to express the same view. It’s your job to find out the most efficient way to deploy your bet, by setting up a cross that exploits the features that you are anticipating. Look at each countries financial and trade drivers and marry up the opposite crosses.
For example:
- if you think Asian economy will outperform the North American economy, long AUD/CAD is a low risk idea
- if you think iron ore has run too far too fast and that oil is bottoming, short AUD/CAD is a low risk idea
- if you think Oil is bottoming but Gold has further to fall, and you also want to be neutral on Emerging Markets, long RUB/ZAR is a funky exotic idea
- if you think Oil has further to fall, but you think the North American economy and Emerging markets should do well, Short NOK/BRL is a decent trade idea
The options are really endless, depending on the drivers you identify. It’s a search for value, in the most efficient way possible. So what are you waiting for? Start viewing the world like a dealer, and your trading will never be the same, for the better.
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.