I mentioned at the start of this chapter that one of the issues that we face as traders in the forex market, is the problem of knowing which currency is driving the pair. When the GBP/USD is rising, is its strength and buying in the pound which is the dominant force, or is it selling and weakness in the US dollar? This problem is compounded by the fact that a currency can be bought or sold against a myriad of other currencies making it extremely difficult to identify where this buying or selling is taking place. A bank that wants to sell euros and buy US dollars, for example, can do so directly, simply by selling the EUR/USD. However, in order to hide their activities from other large institutions, and also avoid moving the market against their own trading, this transaction may be executed using a second or even third currency.
Rather than go from A to B, the bank will get to B via C. If we go back to the above example of selling euros and buying US dollars, this can be achieved by selling euros and buying pounds in the EUR/GBP and then selling pounds to buy US dollars in the GBP/USD. The result is the same – the route is very different. There are, of course, additional costs of execution, but the benefit to the bank is that large transactions can be hidden in this way, well away from the prying eyes of competitive institutions. The Interbank market makers do this, day in and day out.
For single instrument traders in commodities stocks or bonds, this is not an issue, since all the buying and selling is executed through limited channels, either in the cash or futures markets. For foreign exchange traders, life is not that simple, as the alternative options to buy or sell are almost limitless. This is where the currency matrix comes to our aid.
The currency matrix is a very simple concept, yet very powerful, and the easiest way to explain it is with some examples.
Many forex traders, even more, experienced ones, only ever look at one chart when trading, a huge mistake in my view. As you will see in the next chapter, using multiple timeframes is an important feature of my approach to trading, and I hope will become important to you too. The currency matrix uses multiple charts in a different way. In this case, we use the same timeframe, but different currency pairs.
Suppose we are considering taking a position in the EUR/GBP. The pair is moving higher, and we want to establish whether this is euro strength or pound weakness. If this pair were a major, then life would be a little easier as we have the US dollar index as our starting point, but here things are more complex.
We turn instead to our currency matrix for the euro, which is six charts of the principle euro pairs. In this case, we would have the following in our matrix, all in the same time frame which would be relative to our strategy:
Suppose in all these pairs the euro was also rising. What conclusion can we draw from our matrix? Well, in simple terms, the euro is the driving force, as it is rising across all the other currency pairs. In this case, the other pairs are confirming this picture by virtue of the fact that the euro is rising against all these currencies as well, and not just against the UK pound. In other words, the euro is the driving force of the move higher.
The matrix will also tell you something else as well.
If one or more of the pairs is not rising in line with the others, then perhaps the move is lacking some momentum, and therefore unlikely to develop further. After all, if the market is buying euros across all the other pairs, this is a strong signal that the euro is being bought everywhere, and other currencies are being sold.
Finally, the currency matrix also reveals another facet. It reveals the best currency pair to trade. If you are trading euro strength, it will be instantly self-evident from the matrix, which of the euro pairs offers the best trading opportunities based on your analysis. The move higher in the EUR/GBP may be sluggish compared to a move higher in the EUR/JPY or the EUR/CAD. You may see a strong breakout in one pair, which offers a lower risk opportunity than in another, where perhaps the price action is running into a support or resistance area, or the volume is signaling weakness.
In other words, having a currency matrix reveals the complete picture of forex market behavior. The currency matrix is there to tell you what is going on ‘behind the scenes’, and not simply what you see in a single chart. What in effect you are doing in creating this simple matrix, is to ‘see’ the money flow for a particular currency, where the real buying and selling is taking place, and in doing so, reducing the risk on your trading position, which is something we are going to look at in detail in the next chapter. Trading is all about risk, and anything you can do, to help you gauge the risk of the trade and reduce it accordingly is immensely powerful.
In case you are still a little confused, let me give you another example for a Yen matrix. In this case, we would have the following:
Once again you would set this up with these charts using the same timeframe, and the timeframe would depend on your trading strategy. If your approach was short-term or scalping then these would be anywhere between a few minutes and a few hours. For longer-term trading, you might have these on the daily timeframe.
Finally, whilst mentioning multiple charts, the above currency matrix is not the same as trading using multiple timeframes. This is the next stage. The first step is to undertake our initial analysis, perhaps using a currency strength indicator, which is invaluable in revealing in-dividual currency strength and weakness. Step two is to then consider our currency matrix, for the ‘inside view’ on overall strength or weakness in our currency. Finally, in step three we arrive at our multiple charts (generally three) where we have our selected currency pair but viewed in different timeframes.
The currency matrix is immensely powerful and very simple, and I am always amazed that more forex traders don’t validate currency strength and weakness in this way. To me, it just makes sense. If you are trading in the majors, they have a US dollar matrix, and this will also confirm the price movements in the US dollar index. Here, one will validate the other. We also have a yen index, so again, you can have this running in parallel with your yen matrix.
One of the hardest things to do when trading is to quantify the risk on the position before you take it in the market.