Using Relative Strength in Forex Trading: By Justin Paolini

In recent blog posts we have been attempting to shed light on what we’re really doing when trading trends. Today we’re going to take a leap forward and show how we can focus on the stronger performing trends by employing a relative strength measure that blends 3 timeframes and normalizes by ATR.

Trend Trading vs. Relative Strength

In academic literature, the term “Momentum” describes the tendency for assets that have performed well (or poorly) in the recent past to continue to perform well (or poorly) in the future.

Technically speaking, Trend-Following is a particular branch of the broader Momentum strategy group. Trends, in academics, are called “time-series momentum” because a trend becomes evident when the instrument’s current price is higher or lower than some past reference point. There is a vast amount of  literature on time-series momentum, like AQR’s 2017 piece A Century of Evidence on Trend-Following Investing

Trend-following, however, does not make relative comparisons. Professional trend-followers evaluate whether an instrument has had a positive or negative performance over a given trailing period, and apply the same method to (usually) 50+ instruments in multiple markets in order to seek diversification and knowing that trend-following profits are rare, so casting a wide net is necessary.

Source: Trendfollowing.com

However, retail traders and individual investors don’t usually have the kind of risk capital necessary to act as a diversified trend-follower.  Moreover, the actual details of how Dunn (for example) has survived in the more recent years (which have been tough for trend-followers) are proprietary and have much to do with “tweaking” their models.

An efficient solution for retail traders is Relative Strength, or cross-sectional momentum, which is a strategy that attempts to sort instruments based on some trailing return metric and selects the outperformers.  The benefit to retail traders is that you are directed only to the strongest and weakest performers, ignoring everything in between.

Global equities all look similar in terms of absolute performance. However, a relative strength rank would alert traders to focus on the Dax if looking for weakness, or the Nikkei if looking for strength.

Before going more in-depth into our relative strength analysis, keep in mind the benefits we are attempting to achieve:

  • the focus is on making the retail trader’s job easier;
  • relative strength saves time by directing the trader’s focus;
  • a good relative strength measure should allow to compare instruments within the same family (EurUsd vs. EurNzd for example) but also amongst families (AudJpy vs. Copper vs. Nikkei for example).

The History of Relative Strength

In 1838, James Grant published The Great Metroplis, Volume 2. Within, he spoke of David Ricardo, an English political economist who was active in the London markets in the late 1700s and early 1800s. Ricardo amassed a large fortune
trading both bonds and stocks. According to Grant, Ricardo’s success was attributed to three golden rules:

  • “Never refuse an option* when you can get it,”
  • ”Cut short your losses,”
  • ”Let your profits run on.”

The rules “cut short your losses” and “let your profits run on” are foundational principles of momentum. Following in Ricardo’s footsteps are some of Wall Street’s greatest legends:

  • Jesse Livermore (1877 – 1940), who had already discovered that  “The big money was not in the individual fluctuations but in the main movements … sizing up the entire market and its trend”. Livermore in How to Trade in Stocks, would frequently monitor the leaders and the laggards.
  • In the 1930s, George Chestnutt successfully ran the American Investors Fund for nearly 30 years using relative strength techniques and a famous quote says “it is better to buy the leaders and leave the laggards alone. In the market, as in many other phases of life, ‘the strong get stronger, and the weak get weaker.’

The momentum-effect has since gone in & out of fashion, but since the 1990s has been established as one of the principal strategies for investors.

Now that we know what we’re talking about, we can proceed with the legwork done with our programmer in order to analyze and create an efficient relative strength measure for retail traders.

Comparing Apples to Apples: Normalizing by ATR

Various kinds of relative strength measures have been around for decades: the Relative Strength Index (RSI), the Advance Decline Index (ADX), and variations on the theme. However, most traditional relative strength measures do not take into consideration the volatility of the instrument.

The is an issue because if we are only comparing “absolute price change”, then volatile stocks will always win against currencies, or even indices for that matter simply because their oscillations are larger in nature. In order to compare apples to apples,  here’s the approach that we are adopting:

(Close(0) – Close (N periods ago))/ATR 

Momentum ATR using 1Week, 1Month and 1 Quarter lookback period.

The idea of “volatility adjusted momentum” has also been utilized in literature and practitioners for some time, and the evidence is clear: volatility adjusted performance matters more than absolute performance.

As with any technical indicator, the lookback period significantly impacts the results. In order to make the indicator less timeframe-dependant, we decided to blend the timeframes together.

What does the Momentum ATR tell us?

  • The absolute value of Momentum ATR tells us whether the blended volatility-adjusted performance is positive or negative. So in a way, this is a “long vs. short” indicator.
  • The absolute value of Momentum ATR also tells us how strong the movement has been and thus, how much time we have left before the potential end of the move.

However, let’s not forget the real reason for creating this in the first place: being able to rank different instruments against each other! That’s where the relative value of Momentum ATR comes into play.

Scaling by Volatility allows us to compare apples to apples, such as these 4 risk assets. If we have a risk-off theme, it is immediately evident who the weakest instrument is (AudJpy) and thus the easiest to short.

Adding Intraday Behaviour to Relative Strength

We were partially satisfied by our Momentum ATR, but we wanted to dig deeper and verify whether utilizing intraday data (as opposed to Closing prices only) would add any value. The infrastructure we used to take the next step was first made public by Mark Fisher in his good book “The Logical Trader”.

We are in effect using our own variation of his “Macro ACD” concept. To keep things essential, here’s the idea:

  • give each day a “score” based on the kind of volatility-adjusted performance observed. 

Stated in a clearer way, the Macro ACD takes into account the “form” of the Daily candles alongside certain volatility thresholds (% of ATR). We are in effect volatility-scaling intraday movement and then adding up the score over a certain time period.

Momentum ATR vs Macro ACD.

At the present time, the subtle differences between the two indicators are not yet immediately evident, and before releasing our final verdict, further studies are required.

Relative Strength Amongst Currencies

Let’s turn our focus finally to currencies.

The first thing to keep in mind, about currencies, is that they represent “pair trades” – after all, currencies are quoted in “pairs” and there is no official quote for the Euro, Dollar, Yen, etc. All currency pairs are relative value trades in themselves. Another way to say this is:

if you’re long EURUSD, you’re in fact taking 2 separate trades, buying Euros and shorting US Dollars.

So the more accurate way of viewing currency pairs (and any instrument, as we’ll discuss shortly) is: what is the strongest currency, and what is the weakest? If you want to buy Euros for some reason, why buy against the US Dollar? Perhaps the Canadian Dollar is weaker, or the Kiwi. Always attempt to place strength vs. weakness in order to stack the odds more firmly in your favour.

Macro ACD on Kiwi pairs

But in order to properly assess the strength of a regional currency, we need to take into consideration the main crosses of the currency itself. So for example, in order to understand whether the New Zealand Dollar is a strong or weak pair, we need to average out the Macro ACD for EurNzd, GbpNzd, NzdChf, NzdJpy, AudNzd, NzdCad, NzdUsd. In the chart above, the thick black line is the average Macro ACD value for NZD.

Relative Strength FX Screener

By always looking at the highest score vs. the lowest score, you are always trading the strongest vs. weakest regional currency.  Now to evaluate the trustworthiness of what we have built, let’s analyze the top pick of the Macro ACD relative strength meter within the FX market since the beginning of 2018.

On the charts, here is what the selected days looked like:

Now we’re just scratching the surface here, but the initial selection looks good.

Further work will be conducted and published in a  fourthcoming blog post on the subject of finding relative value, because everything in the markets is a spread trade:

  • when you trade the Dow Jones (even if a CFD), effectively you’re trading DOW/USD. But if the USD is strong, perhaps it would make more sense to buy Dow/Eur (buy the Dow, sell EurUsd);
  • when you trade Copper, you’re trading Copper/USD;
  • same with Crude, Gold, and any other commodity priced in USD.

Over to You

Relative strength or cross-sectional momentum is a concept that has worked in the past, continues to work currently and will most likely work equally well so long as human beings will trade the markets since the most reasonable explanations for this behaviour are psychological in nature:

  • Herding (also known as the “bandwagon” effect);
  • Overreaction to new information;
  • Confirmation bias (ignoring information that contraddicts your
    beliefs).

One of the lessons I was taught in the FX boutique I worked for, was to check “what was in play” each day. It was a lesson that was also noted by Agustin Silvani in his book “Beat the Forex Dealer”. Always seek relative value. Scan the crosses of each currency pair and try to trade only when the regional currency is showing strength or weakness across the board. Then match it with the best partner.

Volatility-adjusted momentum allows you to compare instruments from different markets and always pick the strongest (to buy) and the weakest (to sell) depending on the theme in play. FX is the best “school” for learning and applying this mindset, which will allow you to see the markets for the multi-dimensional creature they are.

Embrace relative strength and your trading will never be the same, for the better.

About the Author

Justin is a Forex trader and Coach. He is co-owner of 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.

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