I am a big proponent of correlations. Finding a correlation between two assets that move almost identical is great, but my favorite type of correlation is when one asset leads another. That allows you to trade the asset that is lagging with a lot more confidence. I have discovered a very technical correlation between two different US dollar indices that will allow you to trade the EUR/GBP: the DXY and the FXCM dollar.
First, to understand this correlation we must look at how these two indices are calculated. The DXY measures the dollar against a basket of six major currencies, with a heavy weighting in the euro. The euro makes up almost 58% of the DXY, so it accounts for a lot of its movement. The other 5 currencies are around 10%, give or take. The FXCM dollar index has an equal 25% weighting between four major currencies: the pound, euro, yen, and aussie. The difference in calculations between these two indices causes different currencies to follow one index more closely than the other.
The euro has a stronger inverse relationship with the DXY than it does the FXCM dollar, since it makes up 58% of the DXY and only 25% of the FXCM dollar. Whereas, the pound has a stronger inverse relationship with the FXCM dollar than it does the DXY, since the pound makes up 25% of the FXCM dollar but only about 12% of the DXY. In the chart below, I have put the EUR/USD and GBP/USD side-by-side with the DXY to show there is a much closer inverse relationship between the euro and DXY, than there is the pound and DXY. Also, below that I have the same two currency pairs side-by-side with the FXCM dollar to show the pound has a much closer inverse relationship with it than the euro does. You will notice that sometimes the moves in the euro and pound are nearly identical, but often enough you will see the above mentioned relationship play out, on any time frame. The charts displayed below are just to give you a visual of what I am talking about. We are going to take a more granular look at this relationship in just a moment.
Now, the two dollar indexes move in the same direction, as you can see, but one is usually stronger/weaker than the other. Depending on that strength/weakness, it will determine which direction the EURGBP goes in.
- If the DXY is stronger than the FXCM dollar, that means the euro will be weaker than the pound. Put another way, if the FXCM dollar is weaker than the DXY, the pound will be stronger than the euro. EUR/GBP short is the play.
- If the FXCM dollar is stronger than the DXY, that means the pound will be weaker than the euro. Put another way, if the DXY is weaker than the FXCM dollar, the euro will be stronger than the pound. EUR/GBP long is the play.
Let’s take a look at some examples of how the strength/weakness in the two dollar indices determine the direction of the EUR/GBP. In the first chart below, you can clearly see (indicated by the arrows) that the FXCM dollar’s move down was a lot sharper than that of the DXY’s. That means the FXCM dollar was weaker than the DXY (DXY was stronger than FXCM dollar) which meant the pound would be stronger than the euro (euro weaker than the pound). The result was a move lower in the EUR/GBP.
The EURGBP then reversed its position, alongside the dollar indices. As noted on the chart (below), the FXCM had more buy pressure step into the market than the DXY did. There was then follow through as the FXCM dollar broke the previous candle’s high with some force, whereas the DXY barely broke the previous candle’s high. This showed that the strength that was previously (chart above) in the DXY flowed into the FXCM dollar. If the FXCM dollar is stronger than the DXY (DXY weaker than the FXCM dollar), we should see pound weakness against the euro. The result, was a EUR/GBP long.
To look at it a different way, on the chart below, I identified the strength/weakness in the dollar indices by analyzing which one was breaking pivots (either highs or lows) and which one was not. The 5m candle at 10:45 was breaking a pivot (circled) on the FXCM dollar to the downside, but on the DXY it was failing to break its equivalent pivot low (circled). This indicated that the DXY was stronger than the FXCM dollar (FXCM dollar weaker than DXY), which means the euro should be weaker against the pound. At the same time, the EUR/GBP broke out of its consolidation to the downside, right in line with the DXY strength versus the FXCM dollar.
A lot of the moves that determine which dollar index is stronger/weaker is subtle, but it is there, you just have to train you eye to see it. Also, sometimes the moves in the dollar indices occur at the same time as the move in the EUR/GBP. But, often enough you will be able to determine the strength/weakness in the dollar indices prior to the move in the EUR/GBP. When that happens, it makes it even easier to trade, because the dollar indices are leading the EUR/GBP, giving you its direction before the move happens. Just remember, this analysis can be applied to any time frame and that any move is only relative to the time frame(s) you are looking at.
When performing this analysis you should consider a few things: the angle of the moves – which index has a sharper move? Is one index breaking highs or lows while the other is not? Is one index breaking pivots while the other is not? Is one index creating a stronger buying or selling candle compared to the other? These are the things I look for. But, I never just find one piece of evidence and base a trade off of it. I like to have multiple pieces of evidence to tell me which index is stronger/weaker and then wait for the EUR/GBP to confirm that direction before entering a position, like in the example above.
We just looked at the euro and pound today, but you can get more creative with this analysis. It can be used to trade certain cross pairs, as well as to determine which dollar-based pair will have the cleanest move. I won’t get into that here because what I have gone over is a lot to absorb, but I will in a later article.