It’s time to take a look at how indexes can help you develop a good trading strategy. Indexes allow you to compare a number of charts that contain the two currencies you want to trade, for example EURUSD. This is a vital way of ensuring you are not dealing in a currency which has become overpriced. So how do you do it? Read on to find out…
Why Use an Index?
When trading, you operate on the fundamental principle that value is separate to price. What you want to do is buy a currency you feel is undervalued when compared to another currency, on the assumption that at some time in the future, others will feel the same way and also buy the currency, which will push its price up compared to the currency being sold.
This all seems fine so far: you want to buy currency A against currency B because you feel that at this moment in time it is undervalued by about 50%. If you’re right, then you will be able to buy currency B with currency A, wait until currency B appreciates higher to equal value with currency A, then sell currency B back to currency A, and you have doubled the amount of currency A that you started with. Not bad going!
But before you go ordering your super-yacht having discovered the road to riches, we need to think about this: what happens if currency A only seems worth twice that of currency B because someone else has been selling a lot of currency C in exchange for currency A and not bothered to tell you, so currency A has become overpriced? When currency C reaches what is deemed a “fair value” in relation to currency A, they will want to take profit on their trades, so they’ll buy currency C and sell currency A, which will push the price of currency A down again. Then, when you come to sell your currency B to take profit, currency A will be worth less than you started with, putting you at risk of making a loss.
That’s where indexes come in. What you need to do in order to trade successfully is look at many charts containing your two currencies. That can take a lot of time and means constant monitoring and updating of a lot of different charts. Using an index can make the job a lot easier.
What is an Index?
An index allows you to average many different currency pairs which all share a common currency into one chart. It provides you with a similar insight as looking at many different charts but is less time-consuming, and offers a much broader view of what the overall market sentiment is for a particular currency.
How Do I Use It?
Let’s take a Japanese Yen index as an example. The index might include the prices of USDJPY, EURJPY, GBPJPY, AUDJPY, CHFJPY, CADJPY and NZDJPY.
This index would be very sensitive to movements in the Yen, but much less sensitive to movements of any of the other currencies. This is because the Yen component outweighs the other components by seven to one.
This allows the user to more accurately determine if, overall, the Yen is going up in value or down in value.
You can also use an index to spot when a move in one of your currency pairs is the result of cross currency moves rather than the main index currency. It’s possible for a currency pair to remain static even if both currencies involved are appreciating or depreciating, and this can lead to false signals. Using an index can help you make sure you don’t get caught out.
If you are looking at the GBPJPY chart, waiting for an opportunity to sell Yen, you may see the chart rally and assume that the Yen is weakening. However, if the Yen index is not moving, or only slightly moving, then this tells you that something else is happening. There must be some other pair within the index which is selling off against a strengthening Yen at the same time as GBPJYP rallies, for example EURJPY. So the GBPJPY move is not anything to do with the Yen, and if you were only viewing GBPJPY, you would receive a false signal. The correct trade would have been to sell EURGBP.
Why indexes are a must
Indexes are a vital part of a successful trading strategy because of the three main advantages they offer.
1) They allow you to determine how a currency is performing against the majority of the market, rather than just against one other currency.
2) They allow you to see when cross currencies within the index are moving without affecting the index currency.
3) A chart with an index is less sensitive than an individual chart to general noise from spikes in the individual price of a pair within the index.