Choosing the right currency pair to trade, without the help of a currency strength indicator, is one of the most difficult things for a forex trader. Trying to determine from the price chart which currency is strong and which is weak can be quite difficult and boring. When you consider the effects of intraday noise or try to compare one currency with others, it becomes obvious that estimating the strength of different currencies can seem like an impossible task.
For instance, the JPY may seem like the strongest currency of all the majors on the 5-minute chart, but when you analyze it on the hourly or daily timeframe, you will notice a different thing — maybe, the AUD becomes the strongest currency. So, trying to analyze the strength of currencies based on the naked price action often gives conflicting signals across different timeframes.
Obviously, the price charts can’t clearly show the strength of a currency, which is why the currency strength indicator is specifically designed to compare the strength of multiple currency pairs. It is the secret weapon for successfully identifying the right currency pair to trade.
In this post, you will learn:
- What the currency strength indicator is
- The various types
- How to determine the one to use
- How to create your own currency strength indicator without coding
- The right way to use the indicator
- The mistakes to avoid when using it
What is the currency strength indicator?
A currency strength indicator is a custom-made indicator you can use to determine the currency pairs that are currently trading strongly and the ones that are trading weakly. In other words, it is designed to show the strength of any given currency pair against the others. It uses either the exchange rates of different currency pairs or a specific price parameter to compare the strength of the various currency pairs.
One of the best price parameters for calculating currency strength is the rate of change (ROC). Another parameter for measuring currency strength is the currency correlation, which compares how the movement in different currency pairs are related. Other parameters people use in gauging currency strength include price-based indicators, like moving averages, RSI, CCI, and MACD.
So, there are different formulas for calculating the strength of a currency pair against another, but some of the parameters and the formulas may derail from the central idea of checking how the exchange rate of a particular currency compares to another. Thus, they can give misleading results that may lead you to poor trading decisions.
There are many currency strength indicators out there. In fact, any trader can easily create his own, with or without programming knowledge. In some of the indicators, a sort of weighting is applied to the parameters used in calculating the currency strength, while in some simple forms of the indicators, no weighting is used.
Some very advanced ones don’t just use the percentage change of price over a time period and apply some weightings but also aggregates prices from multiple timeframes to get an indicator that is both effective and efficient in evaluating the currency strength across all timeframes.
Currency strength indicators can be displayed in different ways: It can be displayed as a heat map that plots the major currencies in various timeframes and arranges them according to their strengths and weakness with color codes.
The indicator can also be displayed as a table with color codes for the strengths and weaknesses of the various currencies across the different timeframes. That is, the currencies are plotted against the different timeframes, and for each currency, the different timeframes are shaded in colors that correspond to its strength/weakness.
However, most currency strength indicators are plotted as indicator lines in the indicator window of the charting platform you are using. The individual currencies are plotted as color-coded lines, with each currency represented by a different color, and the position of the lines indicates the strength of the currency — the currency lying at the top is the strongest, while the one at the bottom is the weakest. In some cases, the currencies are plotted as color-coded bars in the indicator window.
Types of currency strength indicator
There are different types of currency strength indicators, and they can be classified in different ways. From our discussion so far, one of the ways to classify them is on the basis of the parameter used in the calculation of the indicator. The tool can also be classified based on how the calculation is done — platform-calculated indicators and manually calculated tool.
Classification based on the parameter used
Based on the parameter used in creating a currency strength indicator, there are different types of the indicator, and they include:
ROC-based currency strength indicator
The rate of change indicator, also known as the price rate of change, is a measure of the percentage change in the current price of a currency and the price at a certain period ago. It ranges from positive values when the base currency is gaining to negative values when the base currency is losing.
It is one of the most commonly used parameters in creating a currency strength indicator. Here, they compare the rate of price change in different currency pairs with a common quote currency by ranking them according to their ROC values.
To do this, the currency pairs to be compared (mostly the major currency pairs) are made to have a common quote currency. The ROC is calculated, and the appropriate waiting applied. In some indicators, values from different timeframes are calculated and aggregated to get the final values for the individual currencies, which are then ranked.
This can be done automatically by an indicator script running on the charting platform, but you can also calculate the ROC values and rank them manually. For an indicator running on the charting platform, the ROC values are plotted as lines or bars in the indicator window or displayed as a table or heat map.
Correlation-based currency strength indicator
In financial trading, correlation is a measure of the relationship between the price movements of two securities, in this case, currency pairs. The value of the correlation coefficient ranges from +1 to -1, where positive values indicate that the two currency pairs move in the same direction, while negative values indicate that they move in opposite directions. When the value is zero, there is no relationship in the movements of the two currency pairs.
For currency strength calculation using correlation, the common currency in two currency pairs that show a very strong correlation is believed to be the one driving both pairs. So, depending on the direction of the price movements, the common currency can be said to be strengthening or weakening — if the price movement is in direction of the common currency (gaining) in both pairs, the currency is strong, but if the movement is away from the common currency (losing) in both pairs, the currency is weak.
Those based on moving average and other indicators
Some currency strength indicators make use of a specified-period moving average or any other price-based indicator. Here, they compare the n-period moving averages of the currencies of interest, after making them have a common base currency.
Classification based on how the calculation is done
Here you have platform-calculated currency strength indicators and manually calculated currency strength tools.
These are preprogrammed custom indicators that are already installed or can be installed on a trading platform. They show the currency strength of the various currencies in real time and can display it as color-coded lines or bars, currency strength table, or currency strength heat map.
Manually calculated tools
You can calculate the currency pair indicator manually using the ROC. The only issue is that it takes time, and you can’t possibly plot the values in real time, unless you are only focused on the higher timeframes, such as the daily and weekly timeframes, where you have enough time to calculate and rank them in each trading session. We will discuss how you can manually calculate the currency strength later.
Which currency indicator should you use?
Is it better to use any of those paid or free custom currency strength indicators for your trading platform or manually calculate the currency strength yourself? Well, our default answer would be to use the one you know works and understand how it works.
If you understand the parameter and formula used in an installable custom indicator for your trading platform and know that it gives the right result, you can go ahead and get it. Platform-installed indicators have the benefit of displaying the values in real time for all timeframes and does not take any effort on your part.
On the other hand, if you are not sure whether your platform currency strength indicator works well and don’t understand how it is calculated or you don’t even have access to an installable indicator, it is cool to calculate it yourself and understand how it works. This way, you know what you are getting and its limits — what it can do and what it can’t do.
Creating your own currency strength indicator that works without coding
Yes, you can create your own currency strength indicator without having to code an indicator or knowing how to code. All you need is to understand how the price parameter you want to use works, know how to calculate it, and choose the currencies you want to study.
The most common and easiest parameter to use is the price rate of change. You simply calculate the values for the various currency pairs of interest and rank them from the highest to the lowest values. If you want, you can use multiple timeframes and add weights to the different timeframes, but this does not add much to the simple version.
Here is how you create a simple version:
1. Make a list of major currency pairs
The first step is to make a list of the currency pairs you want to compare and ensure that they have a common quote currency. Let’s say that you want to compare the major currency pairs, which are as follows:
You can see that all the major currency pairs have USD in common, but USD/JPY, USD/CAD, and USD/CHF have it as the base currency instead of the quote currency. So, you need to use the inverse pairs of these three currency pairs so that all the major pairs you want to compare will have the USD as the quote currency. Thus, your list should look like this:
Interestingly, some trading platforms have inverse currency pairs, so there is no problem with getting them. But if your platform does not show inverse pairs, you can derive them by getting the inverse values of the normal price quotes for all the trading sessions that you need in your ROC calculation. That is, if the USD/CAD closing price for a particular trading section is 1.35457, the closing price for the inverse pair would be 1/1.35457 = 0.73824.
2. Calculate the ROC over the last 10-weeks (50 trading days)
The next step is to get the value of the percentage rate of change over the last 10 weeks if you are on the weekly timeframe or the last 50 days if you are on the daily timeframe. Since you are creating the currency strength tool manually, it is not advisable to use a lower timeframe so that you don’t need to be updating it frequently.
While you can manually calculate the ROC value using the price data, the easiest way to get the value is to insert the ROC indicator on the weekly or daily chart and change the settings to a 10-week or 50-day period, depending on your timeframe — as you can see in the pictures below.
See where to read the value of the ROC below.
Do this for each of the currency pairs of interest and copy the ROC value for the latest trading session. Record these values in Excel or any table you made for them.
3. Rank the currency pairs from strongest to weakest
After getting the values, the next thing is to rank them from the highest value to the lowest value. The currency pair with the highest value is the strongest and would sit at the top, while the currency pair with the lowest value is the weakest would be at the bottom, as in the table below:
Ranking the ROC values
So, what do the different values mean? It is simple: since each of the base currencies (EUR, GBP, AUD, NZD, JPY, CAD, and CHF) have a common quote currency (USD), it means that, at the time of this analysis, NZD is the strongest currency against the USD, followed by AUD, and CAD, while JPY is the weakest currency against the USD.
How to use currency strength indicator
Now that you know what the currency strength indicator is and how to create one yourself, let’s take a look at how you can make use of the currency strength indicator in your trading. While the tool can greatly improve your trading by helping you find the right currency pairs to trade, you don’t just hop into the market because a particular currency pair is the strongest or the weakest at the moment.
However, before we delve into how to use the indicator to find the right currency pairs to trade, let’s take a look at how you can tweak the indicator to suit your trading style.
Tweaking to suit your trading style
If you are using a platform-based currency strength indicator, you don’t have any issues because the indicator adjusts to any timeframe or may even display the signals for each timeframe in a table. However, if you are manually creating your own tool, you may need to adjust the period of ROC in your calculation, depending on your trading style and the timeframe you trade.
If you are an intraday trader or trade on lower timeframes, the 10-week ROC we discussed above may be too long for you. So, you may consider using a 4-week or 20-day ROC, which is more suitable for short-term trading. Those who trade on 4-hourly and daily timeframes can use the 10-week ROC.
Using the currency strength indicator to find the currency pairs to trade
The ability to use the currency strength indicator to find the right currency pairs to trade is based on the principle of the trend — the trend continues until it has been shown to have reversed. Similarly, it is presumed that the stronger currency would keep getting stronger, while the weaker currency will keep getting weaker.
So, with a currency strength tool, you can find currency pairs that are in a strong uptrend or downtrend. It is also possible to use it and find currency pairs that are in a weak trend or a range.
Spotting currency pairs in a strong trend
One of the ways to find a currency pair in a strong trend using the currency strength indicator is by pairing the strongest currency with the weakest one. This gives you a strong trending market. If the strong currency is the base currency and the weak one is the quote currency, you have a strong uptrend, but if the reverse is the case, you have a strong downtrend.
From our example above, NZD is the strongest, while JPY is the weakest. Thus, NZD/JPY gives a strong uptrend, as you can see in the chart below. So, in this pair, you look for buying setups, such as the breakout of a local resistance level and bullish reversal candlestick patterns at price dips.
If you check the inverse pair, JPY/NZD, you will see that it is in a strong downtrend. So, you look for shorting opportunities, such as bearish reversal candlestick patterns at rallies or a downward breakout of a local support level.
Another fairly strong trending market you can get from the example above is pairing the strongest currency against the common quote currency (NZD/USD) as you can see in the chart below.
Spotting currency pairs in a weak trend
If pairing the strongest and the weakest currencies gives a pair in a strong trend, pairing currencies with similar strength would produce a currency pair that is in a weak trend or a range. From our example, pairing CAD with EUR gives a market in a range, as you can see from the chart below. In this kind of market, it will make sense to look for swing trading opportunities.
Mistakes to avoid when using a currency strength indicator
There are some common mistakes traders make when using the currency strength indicator. These are some of them:
Using the indicator without knowing how it works
As with any other trading indicator, you need to know the formula behind the currency strength indicator you are using so that you can know how it works, when it works best, and situations where the results from it may not be trusted. This way, you can get the best out of the indicator and avoid getting the wrong results.
For instance, if a currency strength indicator is meant for only daily and weekly timeframes and you unknowingly start using it on intraday timeframes, you will keep getting the wrong results.
Using the indicator to time your entries
Another mistake you can make is to go long on a currency pair because your currency strength indicator shows that the pair is in a strong uptrend or sell a currency because the indicator shows that it is weak. If you do that, you would find yourself chasing the price most of the time, which would make it difficult to find the right place to put a stop loss, as you can see in the chart below
The right way to use a currency strength indicator is to find currency pairs that are in a strong trend, weak trend, or ranging and, then, use the most appropriate strategy and trade setup for each of those markets. If a currency pair is in a strong trend, you use a trend-following strategy and look for the right trade setup to enter a trade. For a weakly trending pair or a market in a range, you may look for swing-trading setups.
Using the indicator solely on the lower timeframes
Just like any other trading indicator, the currency strength indicator works better on the higher timeframes than on the lower timeframes, and you know why: high impact news and other high volatility events in the market tend to cause price spikes on the lower timeframes and minimal effect on the higher timeframes. So, it is better to use the indicator on the higher timeframe.
The currency strength indicator is very useful in trading the forex market. You can use it to find the right currency pairs to trade at any given time, but it does not tell you when to enter the market. You need a valid trade setup before you make a trade. While there are preprogrammed currency strength indicators, you can create one yourself without coding.