Using Relative Strength to Trigger a Trade

As forex traders we spend a lot of time analyzing yields from the perspective of the primary central bank rates. However, I think a lot of traders are neglecting a source of daily information about yields. In this case, I am referring to relative yields or the performance of two economies' stock markets. This is independently verifiable information that doesn't lag and has an indirect but influential relationship on a currency pair, which can create nice trading opportunities.

The chart below shows the S&P 500 (candles) and its relative strength compared to an index of European stocks. You can see the breakdown on the relative strength line on 8/22, which coincided with the start of a devaluation of the USD. Recently the US stock market has been performing reasonably well and the RS line has been uptrending, which helps explain some of the choppiness in the EUR/USD.

One of the ways that I use this is as a component of an overall fundamental score. It helps contribute to a complete picture of one currency's strength compared to another. From a day to day basis, I may trigger a trade as the relative strength line breaks a previous support or resistance level. A great example is the break on 9/21, which I used to help justify holding a long EUR/USD position. Currently, the relative strength line is back to this same resistance level and beginning to bounce back down. This could be a signal that the correction on the EUR/USD is over and we are headed back up.

We track the relative strength of the major stock markets and smooth the data a little so it can be used as a component of a comprehensive fundamental score. It is not a surprise that the NZD ranks the best on that scale.

S&P 500 RS Graph            Source: MetaStock Pro FX