A Currency Strength Meter Indicator prevents unnecessary hedging and double exposure and determines your trade’s risk level.
How does the currency strength meter work?
If you are still getting familiar with what currency meters do – they compare all 28 crosses between the main currencies in the Forex market (USD, GBP, EUR, CHF, JPY, CAD, NZD, and AUD) to measure their strength. Forex traders can use it to see whether market conditions affect their positions positively or negatively.
Traders can use this technical indicator to make informed decisions about their trading.
The process involves five steps:
1. Determine the base currency
2. Choose a Forex pair that matches the base currency
3. Calculate the relative strength of each pair of currencies
4. Compute the average score
5. Make use of the results
We can use the strength meter as a “filter” when making decisions, allowing us to determine, for example, if the US dollar is strong or weakening, which is incredibly important.
In addition, the strength of a particular currency depends mostly on the timeframe for which it’s used. For example, the EUR can be strong today but one of the strongest in a monthly timeframe.
Currency Strength Indicator Advantages
Indicators of currency strength have three major advantages.
1. Protection from Double Exposure
Taking multiple trades on highly correlated pairs will result in overtrading since they move in the same direction. In such a case, you will lose money if the market does not move in your favor. For example, a highly correlated pair of currencies such as AUD/JPY, EUR/JPY, and AUD/CHF may result in double exposure for you.
When the market moves in the opposite direction to your prediction, you will suffer a huge loss if you become double exposed to JPY and AUD. A Forex currency strength indicator will alert you to such exposure by displaying highly correlated currencies as a simple graphic. In this case, you can protect yourself from double exposure to weak currencies by avoiding trading these currencies.
2. Prevents Needless Hedging
In general, traders can eliminate needless hedging by knowing beforehand the correlations between various pairs of currencies. Consider, for instance, that USD/CHF and EUR/USD have a negative correlation.
In advance, you will know that the market movements of these currencies are opposite if you know that they are negatively correlated. The currency strength meters protect you against unnecessary hedging because if you long trade both pairs, you will lose one trade but win another.
3. Identify High-Risk Trades
If you plan to go long on the currency pairs GBP/USD and EUR/USD, then currency strength meters can also help you determine the level of risk. If one currency is stronger than the other, there is a positive correlation between the two currencies, which indicates double risk.
The other possibility is that one of the currencies may indicate strong market movement while the other may suggest a range. This clearly indicates that traders avoid trading correlated pairs with opposing market movements.
Suppose GBP/USD is range bound and EUR/USD is quickly falling; one shouldn’t take long on the former due to the risk that the USD could be stronger.
Final words
A fundamental rule of online trading is that the tools used to trade must result in profit over time. Currency strength meters are no different. The risk side is too often overlooked when using new ‘fancy’ tools. Getting into foreign exchange trading requires you to be aware that the market is highly volatile, so an asset might experience a breakout or breakdown within a short period. It is, therefore, important to conduct both a technical and a fundamental analysis of the asset you wish to trade before opening a position.
