What is Currency Weighted Average in Forex Trading? Why Currency pairs going up or down?
If EURUSD pair goes up from 1.2500 to 1.2510, the Euro has increased in relative value by 10 pips because either
1) EUR has strengthened, or
2) USD has weakened, or
3) Both EUR and USD have strengthened but relatively at different pace, or
4) Both EUR and USD have weakened but relatively at different pace
But how do you study Euro or Dollar on its own and not as a counter currency of a pair? For example how do you know that how powerful Euro is at a particular point of time. In fact there is no exact way to do it. Some people say studying European indices or European yields may help but unfortunately the correlation among currencies and indices and yields are not always consistent and may lead into misjudgments.
Here I will show you how to study each “single currency” on its own rather than studying “a pair”. If you want to buy Amazon shares, you need to review Amazon market only but in Forex trading if you want to trade a currency pair like EURUSD, two markets should be reviewed, the base currency market and the counter currency market. But the problem is that there is no EUR market or such that and there is no USD market. Therefore, EURUSD can be up about 1% but for the same day another EUR pair like EURGBP might go down for 1%. Then how can we say whether EUR is rising or falling on that day? This can be a lot more complicated when you add other currencies like EURCAD, EURAUD, EURNZD, EURCHF and EURJPY. In other word you might have strong EUR, CHF, CAD, GBP and weak USD, YEN, AUD, NZD. Then how could I come to a conclusion about EUR?
You cannot say that unless you use EUR Currency Weighted Average.
If you make your decision based on EURUSD on that day, you can easily lose all the profit earned from EURUSD by investing in EURGBP and adding the commission you will have a losing day!
Most people when trading a pair, look at one single chart and run their technical analysis based on that single chart only. For example in trading EURUSD, they draw supports and resistance lines or use indicators like EMA, SMA or RSI to predict the direction of the move. In addition they may also review related US and European indices for that day but is it enough? I challenge it as most important pieces of information is missing that how does EUR and USD reacts to other currencies at that point of time.
For EURUSD we should check EURUSD in addition to other EUR crosses like EURGPB, EURJPY, EURAUD, EURNZD, EURCAD and EURCHF. Also USD crosses like USDJPY, USDCAD, USDCHF, GBPUSD, NZDUSD and AUDUSD need to be reviewed too. But how can we review 13 markets before trading EURUSD. The answer is EUR Currency Weighted Average and USD Currency Weighted Average that make us able to summarize all these 13 charts into 2 charts only.
If weighted average Euro shows you that Euro at that particular time is weak and EUR has a losing day, then you would not have gone Long EURUSD even if all your indicators shows you that EURUSD is bullish. Using weighted averages helps you to prevent getting into the trades that are less likely to be winning.
Let’s say you studied your charts and you think EURUSD is bullish and EURGBP is bearish. But when you studied EUR weighted average charts it shows you that EUR is bearish at that point of time, then which one of these trades you take and which one you ignore? Yes, you will go Short EURGBP and wait a bit longer to enter EURUSD Long trade. Even if you argue that what if USD has become weaker recently, which can lead into a great EURUSD, then I would say, there are still plenty of EUR crosses which does offer a better set up.
Market movement for weighted averages
If you are going to trade a pair, you should know how powerful each currency is depending on the time frame you use for trading. If both currencies moving in the same direction, then you should not trade that pair. For example, if both EUR and USD are getting weaker then trading that pair is not appropriate for trading where you can find other currencies that are moving opposite each other. The key point is to find a pair with each currency moving opposite each other.
Where to Start?
Your first objective in trading any pair is to find any 2 currencies that are moving opposite each other. For example one gets weaker while the other gets stronger. In fact this is a basic math, earlier it is mentioned that the quotation EUR/USD (EURUSD) 1.2500 means that one euro is exchanged for 1.2500 US dollars. In other word EUR divided by USD equals 1.2500. This is a ratio and the ratio becomes greater if 1) the nominator (base currency) relatively becomes greater 2) the denominator (counter currency) relatively becomes smaller. Your rate of success in trading EURUSD gets higher if EUR and USD moves in opposite direction with maximum speed for example EUR gets larger and USD gets smaller quickly.
If spend hours of studying your charts but on that particular point of time both EUR and USD moves in one direction, for example both gets weak or strong you do not make any money as in the best situation you need to close the trade at break even. The worst case scenario is when you are Long on EURUSD and EUR gets smaller and USD gets larger then you lose become more and more as time passing by.
How many charts should I study before trading a pair?
The short answer is 3. In addition to chart which you are willing to trade there are two more charts that must be studied in advance which are the weighted averages of the currencies which you want to trade against each other. Here is the list of these 3 charts assuming you intend to trade EURUSD
1) The weighted average of base currency, EUR
2) The weighted average of counter currency, USD
3) EURUSD chart
A lot of people just study the third one, These people are missing two important pieces of information.
Why weighted average and not simple average?
In calculating a simple average, or arithmetic mean, all pairs are treated equally and assigned equal weight. But a weighted average assigns weights that determine in advance the relative importance of each pair. For example, most pair are around 1.00 but JPY crosses are almost 100 time greater than other pairs as usually JPY is 0.01 of other currencies. Using a simple average leads to an answer which heavily depends on JPY movement which is incorrect. Hence, we use weighted averages that takes into account the relative importance of each pair. In the next post I will show you how to calculate Currency weighted average and how to add that into your watchlist in TradingView.
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With kind regards and thanks,
Dr. Ehsan Khansalar
