Many traders come over to the 24-hour and deeply liquid currency market from other asset classes. The reasons for market such a shift are varied; but one thing is the same for those that wade into the new arena: they bring their methods and biases for trading with them. In many ways, the Forex market is very similar to other popular capital markets. Fundamental and technical analysis still applies in equal parts. The presence of retail speculators, large investment banks and commercial hedgers is evident. What’s more, currencies are open to periods of congestion and trends. However, the very nature of a 24-hour market that is driven by broad macro factors means there are bound to be some differences it conditions. With this in mind, we ask a relatively straightforward question: is it better to range trade or trend trade in the currency market. Unfortunately, the answer is more complicated than the question implies (as is the case with most things).
Trying to quantify the trending capacities of any market is difficult and open to debate. Standard measures of activity such as historical volatility, average true range or rate of change can be compared between markets; but they do not offer a meaningful sense of whether one is better for trend-based strategies than another. However, even if we were to compare these readings across asset class, we would come to the general conclusion that the FX market moves at generally the same pace as equities or futures. For an clear picture of this concept, we need only superimpose a historical chart of the Down Jones Industrial Average with one of the EUR/USD exchange rate. The correlation in momentum is just as distinct as it is for direction. Therefore, if you were a range trader in equities, then your strategy can be adapted for range-based scenarios in currencies.
Comparisons aside, there are steps that each trader can take toward adapting their own approach to the currency market so that it better fits a range or trend based pattern. Perhaps the easiest step to take is establishing the correct time frame. Though the FX market is active 24 hours a day, there are intraday periods when volatility is higher and lower than average. There are generally three major sessions that account for most of the liquidity in the market: Asian; European and US (which open in that order). As for volatility though, the ranking is reverse that of the natural open and close times (i.e. US, European and Asian). This is a useful observation as the US shift often sets the pace of the Asian and European sessions that follow it; and the former two will very often hold back from major moves until the New York market is once again online the following day. Therefore, if market participants through US hours maintain a range through the close, the likelihood of such a trend holding through until time the American traders are influencing price action once again is much greater.
Raising the time frame, the conditions for range versus trend are much the same for currencies as they are with most other asset classes. From a technical standpoint, defining rate of change and the presence of horizontal congestion zones in imperative. From a fundamental perspective though, the burden of benchmark volatility can be somewhat less stressful. Establishing the market’s primary drivers (risk appetite, relative growth potential, interest rates, etc) is less complicated and more transparent than stocks or commodities because the scope of the data is much broader. However, it is a rule of thumb that it is easier to identify congestion or trends the shorter or longer your outlook period is. Typically, the period between a few days and a few weeks is the most difficult to gauge.
Another consideration when establishing the proper approach is indentifying the tendencies of a specific currency pair. Different exchange rates can have very different paces. A good comparison can be drawn between AUD/JPY and EUR/GBP. The former has a historically wide carry differential (the difference between the economies’ respective interest rates) which makes it extraordinarily sensitive to even subtle changes in underlying risk appetite. That being said, this is a pair that would have a penchant for erratic behavior and would not be good identifying steady trends or defined ranges unless the underlying market conditions are fully supportive of just such an arrangement. Alternatively, EUR/GBP is comprised of two currencies whose underlying economies are heavily dependent on each other. This acts like something of a stabilizer between the exchange rate as fundamental changes in one currency is oftentimes mirrored in the other. In turn, such a link helps smooth out trends and preserve ranges.
As with any market, the conditions discussed above are just a few of the characteristics that can determine whether the Forex market is better suited for range, trend or even breakout trading. Ultimately, a successful approach is one that is adaptive; and a successful trader is someone that is able to identify when conditions are changing.
John Kicklighter, Strategist at DailyFX.com
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