NoaFX Tutorial

2.2 Absolute vs Relative value of Currencies

In Forex trading, it is very important to understand the concept of currency pairs and how their absolute and relative value of pairs help to trade this instrument in all market conditions and also be profitable by and large.

The Conventional Market

Unlike conventional securities and financial instruments, this security is often bought at a low value and is expected to reach a higher price than the purchase price before selling it for a profit.

Therefore, these instruments will naturally do well only during market conditions. During this period of time it yields a higher positive growth, or which is otherwise known as "boom markets."

However, notice when the markets crash or go through a "bust period", these instruments no longer give positive returns anymore. Most investors or traders at this time, dump their assets, further causing their prices to tank; as supply has been increased and demand has greatly reduced or they hold on to their assets which might be worth a fraction of what they were used to and resign being in such states of "losses" for many years to come.

The Forex Market

In the Forex market, because we don't buy a single currency and expect it to appreciate in value before selling it for profits, these situations will not happen. This is because, we are not speculating on the absolute value of a currency but on its relative value against another currency.

Let's take a closer look at this;

  • If you have $10,000 in your bank account, the absolute value of your savings is $10,000.
  • If you have $10,000 in your bank account and it can get you 5,000 loaves of bread, the relative value of your savings to bread is 5,000 loaves.
  • Now, if the cost of flour or production of bread has doubled and it is now twice as expensive to buy a loaf of bread, the relative value of your savings is 2,500 loaves.
  • Notice that you still have $10,000 in your savings account.
  • Though the absolute value has not changed, the relative value has dropped by half.

So, if we were to apply this in the context of currency trading.

  • 1) If you have $10,000 in your trading account, the absolute value of your trading capital is $10,000
  • If you have $10,000 in your trading account and it can get you 5,000 pounds, the relative value of your trading capital to the GBP is 5,000 pounds, or 2:1
  • Now, if the British economy has done so well and the value of pound has doubled and it is now twice as expensive to buy a pound, the relative value of your trading capital is 2,500 pounds or 4:1
  • Notice that you still have $10,000 in your trading account.
  • Though the absolute value has not changed, the relative value has dropped by half.

The question is, if you knew that the British economy is going to do so well, why wouldn't you change all your trading capital to British Pounds when the relative value was 2:1 and convert back all your British Pounds to your dollar based trading capital when the relative value has increased to 4:1 ?

We hope this gives you an insight as to how we trade the Forex market and its currency pairs. We do not trade based on which currency rises or falls in value, we trade based on which currency rises against which currency and which currency drops against which currency.

Using this valuation context, we can trade the currency pairs regardless of whatever market condition it may be and be profitable consistently.

Here's how;

Steps to Formulating Your Currency Pair
Breaking it down

In forming our currency pair, we want to achieve maximum leverage between the relative difference increase between two currencies. Therefore, we can achieve this by pairing the base currency against another currency which will become our counter currency.

Our aim is to pair two currencies that have the most distinct of differences in their price behavior at that point in time so that we can get maximum "difference" in their positions from the point of your order being open and your order being closed. This difference will be your profits.

If this is difficult to understand, let us explain the same concept in terms of a car race.

In a traditional race (stock market), most betters will have their stakes placed on the car that will finish the race first (the stock that will have the fastest appreciation within that period of time). In a race of say 20 cars, for you to pick the winning car is 1 out of 20. In a probabilistic view, that translates to 5%. Chances of you bagging the winning price or not is 95%.

Imagine if we are to change the rules drastically and your bet would be placed on;

  • A choice of 2 cars which will have the distance between them increase from the time the race starts.
    Or
  • A choice of 2 cars which will have the distance between them decrease from the time the race starts.

For example sake, let us just consider the first rule;

  • A choice of 2 cars which will have the distance between them increase from the time the race starts.

Considering you have unlimited options of the pairs that you can make from these 20 cars, will you;

  • Pair the fastest car vs the fastest car?
    Or
  • Pair the slowest car vs the slowest car?
    Or
  • Pair the slowest car vs the fastest car?

For obvious reasons, most of us will choose option 3. If we had an option, we might also choose to pair a car going in a forward gear vs a car going in a reverse gear!

Trend of the Base Currency

Now, in order for us to select the optimal counter currency, we would need to understand the possible nature of movement our base currency is expected to have against this counter currency.

For example's sake, let us say that our base currency is the Australian Dollar (AUD) and before we can decide on which counter currency to pair it against, we must understand where we are expecting to have AUD move towards. Is it going to;

  • Move towards a higher appreciated value i.e. Buy or Long AUD?
    Or
  • Move towards a lower depreciated value i.e. Sell or Short AUD?

This direction can be determined by discretionary studies using chart patterns or indicators which we shall not go into details for now, but once determined, we are ready to move to the next step.

Choice of the Counter Currency

Once the direction of the base currency has been decided on, we will next choose the counter currency that will give us the best leverage when paired together to achieve the highest relative difference from that point of the position being open.


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