Which Trade Should You Take? How to Filter Your Choices

10/07/2010 12:01 am EST

Focus: FOREX

Sam Evans

Instructor, Online Trading Academy

September has been a busy month to say the least. I have had the privilege of touring the United Kingdom and Ireland with my mentor and Online Trading Academy colleague, Sam Seiden, and taught forex and futures classes, traded my fund, and squeezed a few live Extended Learning Track (XLT) sessions into the mix as well. Trust me, kicking back in October is not going to be a hard adjustment! Now that I have the freedom to do the things I enjoy in life, I find that the busy periods are just as rewarding as the downtime, and I am always excited to meet new and veteran students of Online Trading Academy alike.

It is during these classes and events when I am truly reminded of the diversity of approach, which is available to the modern-day trader or investor. I have met speculators from all walks of life and it is very rare to find a trader with a plan who does not recognize a part of that individual's personality or character traits. As I have often said in previous articles, it is imperative that a consistent trader respects the necessity for disciplined rules, patience, and of course, strict risk management practices. However, part of the journey is also about putting our stamp on our trading activities by creating a trading approach that is in line with our own methodology and belief system. This week, I am going to explore a particular technique to filter the trade selection process, which in my opinion, is a skill to be learned early on in any burgeoning trader's career. One of the biggest challenges the novice trader faces is having too many choices, and I always encourage my own students to use a logical filtering system in their technical analysis to overcome this potential pitfall. Let's take a look at the topic of relative strength (RS) analysis.

For the purpose of this example, I will look at two far-out future potential buying opportunities in the AUD/JPY and GBP/JPY currency pairs. In this case, we have an area of support showing on the AUD/JPY in the 74.00 area:

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Considering this trading idea is featured in a low position on the daily charts, we already know that its extremity offers a solid risk-to-reward potential, which is a key factor in my own trading plan. At the same time, we are also faced with a similar potential trade on the GBP/JPY:

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Demand in this pairing is showing in the 127.00 area of the daily charts and it should be noted that while we are working with two different forex pairings, there are many similarities across both trade ideas, including the decent risk/reward ratios. However, from these charts alone, there are some subtle clues as to which pair may offer the better, or lower-risk, speculation. As I have noted on both examples, the GBP/JPY is showing some signs of weakness in that it has been creating successive lower highs and lower lows for around a year to date. In the case of AUD/JPY, in contrast, this market has been trapped in a more range-like environment over the very same time period, with the recent price activity over the last few months producing higher highs and strength. From this analysis alone, the AUD/JPY is looking like the better buy, but we can also take the outlook another step further.

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In essence, whether we take the AUD/JPY or the GBP/JPY trade, we are effectively taking a short Japanese yen position overall, so for the next stage of the analysis, I have produced a daily chart over the same time period for the pairing of GBP/AUD, as shown below:

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With this chart, we can now measure the relative strength and weakness between the British pound and the Australian dollar. Considering that I am taking a short leg against a weak yen, I am looking to therefore take the trade against it with the stronger of the opposing currency, which, in this case will be either the GBP or the AUD. By pulling up a chart of the GBP/AUD, I can now see objectively that we are in a sustained long-term downtrend with a further short-term downward move in place over the last month or so. This pattern is telling us that the GBP is losing steam against the AUD in that a year ago, one British pound could buy us around 1.85 Australian dollars, and now, we would only be getting about $1.64 for the very same £1.00. The GBP has weakened significantly against the Aussie from what our chart is telling us. Therefore, it could make sense to increase our yen trade success by going on a long leg with the AUD instead of the GBP. This action would also align nicely with the ranging price behavior of the AUD/JPY, when compared with the apparent weakness shown in the GBP/JPY.

Cross-pair analysis in this manner can prove to be a powerful tool in filtering through upcoming trading opportunities for potential consideration. As much as it is the job of a trader to actively participate in market activity, many times it is often the case that we also need to remember to remain disciplined and objectively analytical in our ongoing work routine. In the world of professional trading, I have found that the majority of the time, fewer choices often equate to better profits.

Have a great week!

By Sam Evans, instructor, Online Trading Academy
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