July 10, 2009

Back in the day when I was a stock trader, I became accustomed to how stock shares were quoted. When you bought or sold something, you were always buying only one asset. (For instance, companies like IBM, Google, GE, etc.).

However, when I came over to the currency market, I noticed right away that currencies were quoted differently. Suddenly, instead of buying or selling single companies, I was buying “pairs” of currencies.
At first, I didn’t understand why.

But as with every first-time Forex trader, I was thrown into the deep end of the pool and I quickly learned to swim. I came to understand very quickly how currency pairs work.

Basically, when you’re buying a currency pair, you’re simply buying one currency and selling another.

So if you’re “buying the EUR/USD” you’re really buying the euro, and selling the dollar because you believe the euro will rise against the dollar. If you’re “selling the EUR/USD,” you’re really selling the euro and buying the dollar, because you believe the euro will drop against the dollar.

Easy right?

Even more than that, I realized that every asset is a paired trade when you think about it. For instance, when you buy Google’s stock, it’s really like buying the “GOOG/USD” pair. Why? Because you’re betting that Google will rise much more than just holding dollars or depositing your dollars into a savings account.

So say you believe Google’s stock will rise. This means you also believe that buying Google’s stock is a better investment than simply holding your cash in a savings account. As such, you exchange your dollars for Google’s stock.

In the same way, you value a currency by comparing it to what you think another currency is worth. After all, the dollar could perform one way vs. the euro (EUR/USD) and a totally other way vs. the Japanese yen (USD/JPY).

It’s Simple: Put your Money into the “Best Currency vs. the Worst Currency!”

It’s entirely possible that the dollar could lose value when compared to the euro but gain value when compared to the yen, for instance.

So the dollar’s strength is measured by its strength against another currency. In other words, a currency’s strength is determined by how much of another currency it could buy at the time. If your dollar can buy more foreign currency today than you could yesterday, then your dollar is stronger. If not, it’s weaker.

Always Pair the Strong with the Weak…

Therefore, currencies are a “pairing game.” You always want pair the absolutely strongest currency with the poorest performing currency.

As I often say, “If I could rig a boxing match, I’d want to put the strongest fighter vs. the weakest fighter. Then I would bet on the stronger fighter.”

Well, that’s exactly what we’re doing with currencies.

Some traders determine the “strongest fighter” by looking to the charts to see how well a currency is performing (trending) vs. other major currencies. Yet other traders will look to see which country has the best fundamentals overall and which has the poorest.

No matter what your strategy, you do need to have an opinion. Not only that, you need to have a “strong opinion” on the pair you choose. This will keep you from bailing out of a trade too soon if the long-term trend is still in place.

Time to Choose Sides: Are You Playing Offense or Defense?

Right now, there are “two sides” of economic thought in the Forex market. On one side of the fence, we have traders who believe deflation will carry on and central banks and governments of the world can’t possibly pull us out of it anytime soon.

Those traders are the ones who feel their “strongest currencies” are the dollar and yen vs. most other foreign currencies (especially higher yielding currencies that have the most to move down in interest rates like Australia or New Zealand).

In other words, these traders are now shorting the AUD/USD, AUD/JPY, NZD/USD and NZD/JPY pairs since they feel that the deflation will draw people to the dollar and yen and away from the “high yielders.”

On One Side: Move Aside Recession!

On the other side of the fence, traders believe inflation is returning and that the global economy is on the mend.

They feel that we are past the trough of the global recession and we’re working our way out back into expansionary/inflationary mode and away from deflation and an economic contraction.

These traders are buying the countries with the highest inflation rates (again, like Australia, New Zealand and the U.K.) vs. the defensive plays of the dollar and yen.

So they’re buying pairs like AUD/USD, AUD/JPY, GBP/USD, GBP/JPY, NZD/USD and NZD/JPY for instance.

My View: You Can Always Count on the Government
to Print Their Way Out of Trouble

It will be a while before we see which side wins. Personally, the way I see the fundamental data tilting, it’s all tilting towards the latter crowd rather than the former crowd.

However, whichever side you’re on, if you have an opinion about where the world economy is headed, then you have an opinion you can play in the Forex market with specific currency pairs.

Remember, you always want to “rig the fight” by putting your strongest candidate against what you feel is your “worst candidate” in the currency market. By doing this, you will put yourself in the best position to profit as your worldview plays out.

EDITOR’S NOTE: Now is your chance to learn all the ins and outs of trading currency pairs. This past April, three currency experts explained all their most closely guarded secrets to trading both major and exotic plays to a packed house in video. The good news? We were there recording this whole Three-Hour Currency Crash Course. You can secure your copy here.