Today’s blog post is in response to a client’s question: “How can I find the best instrument to trade each day?”. To confront this question appropriately, we need to distinguish between trade idea generation (what to trade and why), and setups (how to enter). Unfortunately most traders mix or confuse these two terms, and basically scroll through chart after chart “looking for setups”.
Fortunately there is a better way which is both more efficient and effective at selecting high-quality opportunities. Most professional traders use a very similar routine when preparing their day, so let’s explore how to generate high probability trade ideas.
Where is the Focal Point?
The first thing to do is think of creating a routine that allows you to scan for high-probability trade ideas. The first part of this routine consists in keeping up to date with market sentiment. Here are the key questions to ask:
What is the key theme for the week? This will direct trader’s attention. Recently the market has been concerned about President Trump’s Tariff War against China. Then there is the global economic slowdown which has been in the news for the past few weeks. How do you know what the themes are?
We wrote a detailed explanation of how to do this here.
Then, once you have the main picture created on a Saturday or Sunday, just update the picture each morning by reading through the overnight developments. A simple way to do this is to read our Morning Report in the Dealing Room.
Intermarket Capital Flows
Once you have the main themes and drivers in mind, the next step is to see how the market is reacting to those themes. We live in a global economy and as such, we cannot consider one market in isolation. To master the markets we must learn to view all markets together: this is the basis for intermarket analysis.
There are two key starting points for understanding Intermarket Analysis: the role of the US Dollar and the role of Commodity Prices (the CRB Index).
Bond and stock prices are both influenced by the dollar: usually bond yields (not prices) rise when the US Dollar is in demand. And when the US Dollar is in demand, stock prices usually drop (partially because they are priced in USD, so they become cheaper, relatively speaking).
However, the USD impacts bonds and stocks more profoundly through the commodity sector. Movements in the dollar influence commodity prices, because they are priced and traded in USD. Commodity prices influence bonds, which then influence stocks. To understand why this is the case brings us to the critical question of inflation.
The bottom line is that rising commodity prices are inflationary, while falling commodity prices are non-inflationary.
Here is the economic reasoning: during a period of economic expansion, demand for raw materials (Copper, Iron, Steel, Crude Oil, etc) increases along with the demand for money to fuel the economic expansion. Basically, commodity prices tend to rise alongisde interest rates. At a certain point, the rise in interest rates blocks further lending, and the subsequent economic slowdown follows, with lower demand for commodities and lower demand for capital. We went more in-depth on that here.
It thus follows that: rising commodities will make market participants discount future inflation and bond prices should rise. Stocks might follow with a lag, because usually bond markets anticipate stocks.
And then we have the more common and well-known correlations:
- Gold UP = USD Down, AUD UP, CAD UP;
- Crude Oil UP = USD Down, CAD UP;
- Dow UP + Bond Prices Down = JPY Down (AudJpy Up, NzdJpy Up) = Risk-On
- Dow Down + Bond Prices Up = JPY UP (AudJpy Down, NzdJpy Down) = Risk-Off
We wrote about some other correlations here. For a more in-depth read, I would suggest John Murphy’s book on Intermarket Analysis. You can setup a quick screen for intermarket analysis on TradingView.
Finding Common Themes
Once we know whether there is any particular theme playing out across the global markets, we can then focus on FX. Sometimes there is nothing really going on, and everything looks disorganized. Sometimes there is a clear risk-on or risk-off agenda. Other times the USD will be on a tear and put pressure on commodities and emerging markets.
This background information can help you understand where the higher odds plays may be, on any given day, within the FX universe and all you need is a simple heatmap (like our Market Type Heatmap) to verify that those themes are playing out in FX as intended.
For example, at the time of this screenshot, the Kiwi was having a good run. But before taking a position, I want continued confirmation that Kiwi is the flavor of the week or if something else is stealing the spotlight of late. So here are questions to work your way around the Heatmap:
- What is the USD doing? Being the world’s reserve currency, it is often the main focus in FX..but not always.
- Run the ruler across Gbp, Euro, Yen, Usd against their main trading partners. Is any of them dominant or passive across the board?
What we’re trying to do is make sure that the strength of NZD is not an exception limited to NZDUSD. Before buying the NZD, I’d prefer to see it strong across the board. It’s then a case of matching the strongest vs. weakest, to see if an opportunity exists.
Obviously if the sentiment work in step 1 highlighted a certain theme on New Zealand, it gives you extra confidence. If you also see rising Gold prices or if there were a risk-on agenada playing out, things would look even better.
Over to You
Creating good habits is what this is all about. In order to find quality each day, you can simply create your own version of the 3-step process described above:
- Identify Key Themes and Current Sentiment
- Scan the Intermarket to view how these themes are being digested
- Finally, zoom into FX and with the help of a heatmap identify common themes playing out.
Then, selecting the best setups to express the idea should be a piece of cake.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals and Education 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.