Relative Value in the Forex Market and How You Can Use it to Your Advantage
Relative value is a fundamental factor that can be used to help identify potential trading opportunities in financial markets. The methodology is a common way for stock market participants to gauge the strength and value of a stock before investment. It can be applied to various other markets, including forex. Simply put, relative value compares similar financial instruments to attempt to predict a coming movement.
In the stock market, the investor may be interested in the manufacturer of a CPU. The investor may then turn to stocks of the manufacturer's competitors to see how they are performing in the market. The stock may be over or undervalued in comparison to the competition creating an opportunity for longing or shorting the stock. If the competition is posting strong numbers and the manufacturer is faltering, then it may indicate a bad time to invest or the perfect time to get on the ground floor.
The same methodology can be applied to the forex market. We see this most often in correlative and inversely correlative pairs. This form of fundamental analysis can also be derived from other markets or currency indices. Instead of checking the competition's stock, we are checking currencies and pairs that are related.
Relative value is a tool best employed alongside a more refined means of finding an entry and exit.
Comparison to Gauge Currency Strength
The primary benefit of relative value comparison is in ascertaining the potential strength of a currency trade. It can also be used to help determine the proper time to exit a trade.
Example: A trader has an open long on the EURUSD that has been in a mild uptrend. A look at the individual indexes of the component currencies of this trade may help the trader decide if it is time to step out of the market or not. A look at the Dollar index shows a weakening dollar, whilst a look at the Euro index shows a stronger Euro.
Correlative and Inversely Correlative Pairs
Correlation is another strong indicator that forex traders need to understand. Certain pairs share a relationship with one another and tend to mimic one another's movements. This can be very helpful in identifying the best set up across the correlated pairs. For example, the Euro, Great Britain Pound, and Swiss Franc all tend to move in a similar fashion. Pairs like EURUSD, USDGBP, and USDCHF can be very similar.
A trader that spots a set up on a correlated pair will want to avoid taking trades out on the other correlated or inversely correlated pairs. Inversely correlated pairs will have one moving up while the other moves down.
Here’s a brief list of correlated and inversely correlated pairs:
EUR/USD + GBP/USD
USD/CHF + USD/JPY
EUR/USD + NZD/USD
AUD/USD + EUR/USD