Dirty Shirts & Forex Trading
02/25/2013 6:00 am EST
When forex traders ask which currency pairs are the best ones to trade, and they are usually advised to trade a strong currency against a weak one, but Rick Wright of Online Trading Academy says that sometimes it's not so easy to tell the strong from the weak.
Hello traders! You know it. I know it. It seems as though most people don't get it. The economies of the major currencies out there are in bad shape. If you listen to the talking heads on the major business channels on television, things have turned the corner and are getting better. "The stock market is at multi-year highs!" they will say. While this is true in some cases, it doesn't take a PhD in economics or mathematics to understand why.
With the major central banks printing money out of thin air-actually not printing, but just adding a few zeros to their Excel spreadsheets-this money has to go somewhere. Where on earth would you put that extra money to work? Since most major currency bonds pay a GUARANTEED loss when inflation is counted, why not pour money into the stock market? It's been going up, might as well jump on that bandwagon!
So why would a central bank print more money? The idea is to weaken their currency enough vs. the other major currencies to spur on economic growth in their local markets. The weaker the currency, the more exports the country should have, inspiring job creation at home. The stronger the currency, the cheaper imports will be-which would be good for consumers when they go shopping, but not so good for job creation. Because central banks and governments want the higher tax revenue and general feeling of well-being that comes with higher employment, each is trying to weaken their own currency.
But inflation-that is, trending higher prices-is low, you might say. While we are told the Consumer Price Index (CPI) in the U.S. is about 1.7%, personal experience and alternative sources will tell you that inflation is much higher. When looking at how the CPI was formerly calculated, it is running closer to 6% per year, approximately three times what we are told! (Peter Schiff and John Williams have both done a terrific job in discrediting the numbers we are told.) If most people knew what the real numbers were, perhaps they would vote differently.
So, each central bank and government wants a weaker currency. Normally in the forex market, I would look for trades where one currency is getting stronger while another is getting weaker-these trades will usually be the most profitable as they show the strongest moves and longest trends. But with each currency getting weaker, how can we determine which to be long and which to be short? That is where the cleanest dirty shirt comes into play. Since each currency is by itself a "dirty shirt," we have to determine which is the cleanest of them. Give me the cleanest dirty shirt vs. the dirtiest dirty shirt and I can make a trading decision.
NEXT PAGE: Examples to Illustrate|pagebreak|
In the following charts, you can easily see which central bank is "winning" the race to create a weaker currency-a dirtier shirt than the others, if you will. When considering the AUD/USD pair, it has been stuck in a trading range of approximately 450 pips since last August AUD/USD-with a daily Average True Range (ATR) of a paltry 73 pips at the time of this writing. Both shirts look to be equally dirty, not the best trending pair to trade!
In the case of the EUR/USD pair, the range since August has been a terrific 1500 pips! With a daily ATR of about 108 pips, you can plainly see that the USD is the dirtier shirt than the EUR. The US central bank is winning the battle for a weaker currency! At least for now.
How about the USD/JPY? In the same time frame, the range has been a pleasing 1650 pips, with an ATR of about 112. The Japanese central bank is certainly winning the dirty shirt race against the USD!
Let's see, if the USD is dirtier than the EUR, and the JPY is dirtier than the USD, who is the cleanest shirt of these three, and which is the dirtiest? Logically, the EUR is the cleanest, and the JPY the dirtiest. Let's take a look at that chart.
This chart shows an astounding 3200 pip move, with a daily ATR of about 212 pips! Clearly, the Japanese central bank is winning the battle of the dirtiest shirt on the floor.
So what is the main lesson here? When choosing a pair to trade, finding a strong economy (currency) to trade versus a weak economy (currency) isn't always an easy task. Because of the relationship trade of our currency pairs, sometimes finding a weak currency vs. a VERY weak currency is what we are stuck with. Looking at the previous AUD/USD chart, you can surmise that both shirts are equally dirty, and your trades have probably been short term, giving you fewer pips. If you have been fortunate enough to notice the EUR/JPY pair and been long over the past few months, congratulations! This trade may have made your entire year profitable!
On a side note, most of the JPY pairs have run into significant supply dating back three-five years, depending on the pair. While the trend is still up, I would prefer a significant retracement to a good demand zone before going long against the JPY. Always keep our core strategy in mind, take the small losses and let those winners run!
By Rick Wright, Instructor, Online Trading Academy