Raghee Horner shares why professional currency traders follow the Dow and equities even though they don't trade them directly.

If you are strictly a currency trader, you may not think that following the Dow or the stock market in the US is important, but here are some reasons why you should.

If I'm a currency trader, I'll give you an idea of what I do every morning. I start off with understanding what the risk environment is, which means are traders interested in buying equities or are they interested in selling equities? Because then there is a complete relationship back to the US dollar, which all forex traders have to keep an eye on, and back to commodities like crude oil, which again forex traders have to keep an eye on.

For example, if I'm dealing with a downtrend in the Dow, and I see that there might be an exhaustion or a correction—or some sort of ceiling that is going to stick—I know that the dollar at some point is going to be under pressure, or it might be rallying. If it is weakness in the Dow, look for dollar strength. If it's weakness in the Dow, look for crude oil weakness.

So how do we equate that back to the pairs? Look at the yen. The yen is what I call the risk barometer. Even equities traders should be looking at the Japanese yen. That would be pairs like the aussie/yen, the euro/yen, and the dollar/yen. Look to see if the yen is strengthening against its counterpart, and if it is you're probably looking at a risk-off environment.

It's kind of like the carry trade. If there is risk appetite in the market, people are feeling greedy. People are feeling risk is on the table. They are going to sell or borrow the yen—that is the carry trade. When they're not feeling like risk is on the table, that's when they are going to buy it, and that is when you see the risk aversion work its way into the market.

What we'd love to have, of course, is some sort of leading indicator that says when the Dow starts to go down that we have some time to get in to the yen or something. We do have something that sort of works like that.

I always bring up that May 2010 flash crash. I know it's painful for some, but actually the aussie/yen and the euro/yen broke down almost three hours before we had the flash crash. So there was a lot of yen buying indicating fear, indicating risk aversion, and then the Dow came. It's not always leading, but there is a relationship that you want to keep an eye on, because if they start to separate too much something is happening. The Dow and the yen should not necessarily be moving in a way that we see the Dow's strength, but we see yen's strength as well. It should be an inverse relationship.

Some of you might be wondering if you're not trading stocks at all, should you start trading some equities—maybe some ETFs or broad index funds—when you're not trading currencies and take advantage of both sides. Maybe short one and go long the other.

I look at it as one mind, many markets. When you understand that common thread that goes from—say the Dow to IBM to the yen all of a sudden—the whole market becomes your playground. Even if I'm a currency trader—whether it be futures or whether it be spot—if I'm a currency trader, I still need to keep an eye on what kind of risk appetite there is in the market.  Because if the Dow is leading the psychology, then I need to at least pay attention to what's happening there, because it is going to affect the way the yen is being bought or sold, or even the US dollar.

Learn more about Raghee Horner at SimplerTrading.com.