Forex Pair Performance Strength Score

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Forex Pair Performance Strength Score Page 1of 10

Issue 50 Wednesday, September 11, 2013

Forex Pair Performance Strength Score

Michael Burke

Vice-president of Client Training and [email protected]

Features Studies/Files Included:

Focus: Technical Indicators

Markets: Forex

Workspace Time Perspective: Intermediate term

Overview

With dozens of forex pairs available to trade and analyze, the performance relationships among all thesepairs give us an opportunity to measure which currencies are performing relatively stronger or weakercompared to other currencies, and to find the pairings that might best exploit these relative strengths andweaknesses.

The Forex Pair Performance Strength Score concept is presented here as a set of tools to measure andmonitor these performance relationships and assign a strength score to each individual currency and also to

each currency pair. This is done by examining the performance of each currency across all its pairs and thencombining the scores of the two currencies in each pair.

This paper will focus only on the eight major (most widely traded) currencies: U.S. dollar, Japanese yen,euro, Swiss franc, British pound, Canadian dollar, Australian dollar and New Zealand dollar. These eightcurrencies represent 28 unique tradable currency pairs.

Forex Pair Symbology

This section is a brief review of the basic principles of a forex pair symbol. Although many readers mayalready be familiar with this, it is offered here because an understanding of forex pair symbology andterminology is necessary in order to fully appreciate the concepts and methodology of the Performance

Strength Score.

Each cash forex symbol comprises two underlying currencies:

Base Currency (EURUSD)

The base currency in a forex pair symbol is the first symbol noted. In the case of EURUSD, thebase currency is EUR (euro). This is the currency you are buying or selling. For example, if yourtrade size is 100,000 units, you are buying or selling 100,000 euros against U.S. dollars.


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Quote Currency (EURUSD)

The quote currency, sometimes called the secondary or terms currency, is the second symbol in aforex pair. In the case of EURUSD, the quote currency is USD (U.S. dollars). This is the currencyprice being quoted. For example, if EURUSD is currently quoted at 1.3310 bid / 1.3312 ask, thenyou would pay 1.3312 U.S. dollars to buy 1 euro and receive 1.3310 U.S. dollars to sell 1 euro. The

realized profit or loss of a trade is always based on the quote currency. TradeStation automaticallyconverts this into your native account currency at the end of the session based on the currentconversion rates.

Figure 1: Forex Pair Symbol Terminology

Measuring Forex Strength

The first step in measuring the Forex Strength Score is to calculate a relative strength score for each of the

eight major underlying currencies individually. This is done using the seven forex pairs that contain eachunderlying currency.

We calculate the performance for each of the seven forex cash pairs using a smoothed momentumpercentage. Specifically, we use the 3-bar simple average of the 13-bar percent change.

Since there are two currencies represented in each forex pair, if the momentum percentage for the pair ispositive, then the score value for the base (first) symbol in the pair is also positive and the score value forthe quote (second) symbol in the pair must be negative. For example: if EURUSD has a positive momentumpercentage value of .55, then the EUR would get a positive score value, +.55, and the USD gets a negativescore value, -.55. We then accumulate the scores for each of the seven unique forex pairs to come up withthe raw performance score for the underlying currency. In other words, we look at all seven pairs thatcontain the EUR and add up the scores:

Euro Score = (EURAUD + EURCAD + EURCHF + EURGBP + EURJPY + EURNZD + EURUSD)

This formula is a little different for currencies that are not the base (first) currency of the symbol. Forexample, U.S. dollar:

U.S. Dollar Score = (USDCAD + USDCHF + USDJPY) - (AUDUSD+ GBPUSD+ EURUSD+ NZDUSD)


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Notice that we must subtract the scores when the score currency is the quote (second) currency in thesymbol, since a negative performance score for that pair actually means the score was positive for the quotecurrency. Lets plug in some sample performance numbers to illustrate the idea.

U.S. Dollar Score = (.5 + .6 + (-.4)) - (.7 + .5 + (-.3) + (-.4)) = +.2 (Raw Total Score)

This raw score for each underlying currency is then normalized to a larger number that can be comparedand sorted more easily in charting or RadarScreen.

Euro Score Illustration

Table 1 shows the smoothed momentum percentage for each of the seven related euro currency pairs. It isthese momentum values that normalize or combine into the Strength Score for the underlying euro currency.

The normalized score formula is the sum of all pairs related to a currency using average momentum percentmultiplied by 1,000 and divided by 7.

Table 1: Table wi th Forex Pair Smoothed Momentum Percentage Values and Final Score for Euro

EURAUD EURCAD EURCHF EURGBP EURJPY EURNZD EURUSDRaw

Score

Performance -0.00160 0.01760 0.00060 -0.01260 0.00640 0.00710 0.00560 0.02310

Euro Strength Score 3.35

Calculating the Strength Score for Each Forex Pair

Once we have the normalized score for each of the eight major underlying currencies, the normalized scores

for the two underlying currencies in a specific pair make up the Strength Score for that pair. We thencalculate this final Strength Score for each of the 28 forex pairs.

Table 2 shows the Strength Score for each of the major currencies.

Table 2: Strength Score fo r the Major Currencies

AussieDollar

BritishPound

CanadianDollar

EuroJapanese

Yen

NewZealandDollar

SwissFranc

U.S.Dollar

FX Strength Score4.77 18.19 -16.82 3.46 -4.22 -5.02 2.56 -2.93

(Daily Interval)

The strongest and weakest underlying currencies in table 2 are the British pound and the Canadian dollarwith Strength Scores of +18.19 and -16.82, respectively, yielding a Strength Score of 34.92 for the pair. Wetake the Strength Score of the British pound and subtract the Strength Score of the Canadian dollar asfollows:

(+18.19 - (-16.82)) = +35.01


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Figure 2: Strength Scores for the 28 Major Pairs

Calculating this score for all 28 pairs, we can sort and rank the list of forex pairs in RadarScreen in order tofind the strongest and weakest pairs relative to each other.

The weakest pair in figure 2 is CADCHF with a Strength Score of -19.38, the result of the Canadian dollarscore of -16.82 and the Swiss franc score of +2.56 (table 2):

(-16.82 - (+2.56)) = -19.38

Since the Canadian dollar is the weakest underlying currency, it will have a reverse score effect when it isthe quote (second) symbol in the pair, placing those pairs among the strongest/bullish (for example,GBPCAD or AUDCAD).

Charting the Forex Pair Performance Strength Score

The historical values of the Strength Score for an individual forex pair can be plotted in a chart in order togauge the trend of the score and to see any visual correlations between the score and the price action. Theplot of the TSL: FX Pairs Strength Score CH changes color from red to green, or vice versa, as the scorecrosses above or below 0.


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It is important to remember that the score for a single cash forex pair is derived from the total score of thetwo underlying currencies that make up the cash forex symbol.

Figure 3: EURUSD with TSL: FX Pairs Strength Score CH

Charting the Strength Score for the Underlying Currency

Figure 4: EURUSD with TSL: FX Currency Strength Score CH


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It is not enough to know the momentum of just a single pair; it is equally important to know the trend of theStrength Score for each of the underlying currencies that make up the pair. For example, if we are goinglong EURUSD, it would be nice to know if the euro score is trending up and the U.S. dollar score is trendingdown in order to confirm the trading signal. The TSL: FX Currency Strength Score CH indicator plots theStrength Score for each of the underlying currencies of a forex pair. You can see that when the twounderlying currency scores cross, the TSL: FX Pairs Strength Score CH indicator for the forex pair crossesabove or below zero on the same bar.

Note: If the symbol in the chart is not a currency pair, the indicator will plot values for all eight underlying

currencies.

One possible application of this information is to confirm a trading signal by waiting for one underlyingcurrency to be above zero and trending higher and the other currency to be below zero and trending lower.To help visualize this concept, the TSL: FX Pair Strength Score CH plots a tick mark whenever oneunderlying currency score is above zero and the other is below zero, in the direction of the pair score.

Scanning the Forex Pair Strength Score in RadarScreen

RadarScreen gives us the opportunity to see all 28 forex pairs together so we can sort and rank these pairsby their Strength Score.

In the RadarScreen window in figure 5, we can see that the GBPCAD has the strongest Strength Score,using a daily bar interval; CADCHF has the weakest.

Colors are used in the RadarScreen cells to help identify several conditions:

Green font= Strength Score is positive.

Red fon t= Strength Score is negative.

Green background= Strength Score is positive and base currency Strength Score is positive andquote currency Strength Score is negative. That is, the individual Strength Scores agree with thepositive Strength Score of the pair.

Red background= Strength Score is negative and base currency Strength Score is negative andquote currency Strength Score is positive. That is, the individual Strength Scores agree with the

negative Strength Score of the pair.


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Figure 5: RadarScreen Window wi th Pairs Sorted by Strength Score

Traders might use this data to explore taking a long position in one of the stronger pairs and a short positionin one of the weaker, using the background color to confirm that the Strength Score of the long currency ofeach trade is trending up and the Strength Score of the short currency in each trade is trending down.

You may also want to make sure the two pairs are not overly correlated. In this case, you would probably notwant to trade both GBPCAD (long/strongest) and CADCHF (short/weakest), as both symbols contain CAD.It might be better to find a non-CAD pair for this. In this sample RadarScreen, the weakest non-CAD (andnon-GBP) pair is the NZDCHF, which might be a good alternative short candidate.

Note: For a discussion of forex correlation and tools for monitoring it, see the Analysis Concepts paper titledUnderstanding and Using Correlation Analysis.

Indicators

There are three indicators provided with this Analysis Concepts paper.

1. TSL: FX Strength Score RS2. TSL: FX Pairs Strength Score CH3. TSL: FX Currency Strength Score CH
http://www.tradestation.com/en/education/labs/analysis-concepts/understanding-and-using-correlation-analysishttp://www.tradestation.com/en/education/labs/analysis-concepts/understanding-and-using-correlation-analysishttp://www.tradestation.com/en/education/labs/analysis-concepts/understanding-and-using-correlation-analysishttp://www.tradestation.com/en/education/labs/analysis-concepts/understanding-and-using-correlation-analysis


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Calculation procedure note: In order to process the intensive calculations and data requirements of theseindicators more efficiently, the indicator values and plots update every 10 seconds and not every tick.

Indicator -- TSL: FX Strength Score RS

The TSL: FX Strength Score RS indicator calculates and plots the Strength Score across all 28 majorcurrency pairs in RadarScreen. This indicator will not work in the Quotes window.

Plot Description

Score Plots the Strength Score for a currency pair.

Input Default Description

MoLength 13 The number of bars used to calculate the momentum percent value

BarsToLoad 126The number of bars of historical data to load; this value should be at least doublethe MoLength Input plus 100 bars to match the data loaded into each row.

Note: The indicator also loads an additional 150 bars of historical data automatically to stabilize thecalculations when needed. Always double check that the RadarScreen values match the values in charting.If they do not, you may need to add additional bars of historical data.

Indicator -- TSL: FX Pairs Strength Score CH

The TSL: FX Pairs Strength Score CH indicator is the charting version of the RadarScreen indicator above.It plots the Strength Score for any of the 28 calculated forex pairs historically and in real time.

Plot Description

Score Plots the Strength Score for a currency pair.


MoLength 13 The number of bars used to calculate the momentum percent value.

BarsToLoad 500The number of bars of historical data to load; this value should be the same as thenumber of bars loaded into the chart.

Indicator -- TSL: FX Currency Strength Score CH

The TSL: FX Currency Strength Score CH indicator plots the strength score for the two underlyingcurrencies that make up the forex pair in the chart. The indicator will plot all eight underlying currencies if thesymbol in the chart is not one of the 28 calculated forex pairs.

Plot Description

There are two plots; plot names vary basedon the pair in the chart.

Plots the individual Strength Scores of the two currencies in a pair.


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MoLength 13 The number of bars used to calculate the momentum percent value.

BarsToLoad 500The number of bars of historical data to load; this value should be the same asthe number of bars loaded into the chart.

Data note: All of the indicators discussed in this document operate on a fixed set of symbols that cannot bechanged. The 28 forex cash pair symbols are:

AUDCAD AUDCHF AUDJPY AUDNZD AUDUSD CADCHF CADJPY

CHFJPY EURAUD EURCAD EURCHF EURGBP EURJPY EURNZD

EURUSD GBPAUD GBPCAD GBPCHF GBPJPY GBPNZD GBPUSD

NZDCAD NZDCHF NZDJPY NZDUSD USDCAD USDCHF USDJPY

Conclusion

The Forex Pair Performance Strength Score presented in this paper uses the most basic principles ofmomentum and relative strength to produce a detailed look into the interrelated dynamics of the cash forexmarket. It can provide a high-level overview of how each currency is performing relative to the others,identify which currencies may be in trends that are accelerating or decelerating, and provide a number ofuseful data points and visuals to encourage new trading ideas and models to explore. Of course, a technicaltool such as this is only one part of a comprehensive forex trading plan.

The primary application of the Strength Score concept is symbol selection: that is, identifying those symbolsthat have the greatest potential based on their relative ranking and performance within the group of 28symbols. Tracking the trend of the Strength Score can also be useful in developing entry and exit rules.

Longer-term trend traders can utilize this concept on daily or weekly bar intervals and adjust the length inputfor the momentum calculation as desired. Remember, however, that longer input values tend to exaggeratethe indicator lag effect.

Intraday traders can use multiple time frames/intervals (intraday, daily, weekly) to gauge and confirm themode or direction of a currency and then use that information to develop or augment intraday tradingdecisions.

One possibility for further development of the Strength Score is to track over time changes in the relativeranking of each symbol compared to the others. This ranking could be displayed over a historical period tomonitor the relative movement of each symbol within the list. This would allow the trader to more easily seewhich symbols were moving up and down within the list, determine how long a symbol had been at aspecific level, and better identify trend reversals and rotations of strength.


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