When trading the FX market, one of the advantages traders have is the use of the currency pairs as a basis of comparison. Each FX pair provides us with a price that represents the relative value of one currency against another. We cannot only determine which currency within the pair is relatively stronger, but we can also determine which individual currency is relatively stronger or weaker against all others. For example, if we believe the USD has a good chance to move lower in the near future, a trader logically may look to go long either the EUR/USD, GBP/USD, or perhaps the AUD/USD. Through the use of the EUR/GBP pair, we can also determine which currency (either the EUR or GBP) is relatively stronger or weaker against each other.

Ideally we should always try to go long the strongest currency, and at the same time, sell (short) the weakest. For example, the following daily chart illustrates how the EUR/GBP can be used to determine at what points the EUR is relatively strong or weak against the GBP. A trader should try to go long the EUR/USD not only when the USD has a good chance to decline, but also when the EUR has a good chance to appreciate against the GBP. By using the EUR/GBP pair, we can determine when the EUR is the strongest or weakest against all other currencies.

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Can you more clearly explain how to use the EUR/GBP as a reference point for trading the EUR/USD?

We can see a trend line drawn on the EUR/GBP from May 25 to December 29. As the EUR/GBP faces resistance and reverses, we can see that the EUR/USD also faces resistance and then falls after hitting a peak on December 29.

When should I buy the EUR/USD based on the EUR/GBP?

Notice the support on the EUR/GBP around June 11. There is clearly support on the EUR/USD as well and we should use the EUR/GBP chart to confirm a long position on the EUR/USD. Notice that after the level of support holds, the EUR/USD climbs more than 1500 pips, resulting in an excellent trade.

How strong is the correlation? Is it strong enough that I can place a reversal trade in the EUR/USD based on a reversal in the EUR/GBP?

Remember that the best trades are going to be the ones that we can confirm using multiple indicators. For example if we do see a top reversal in the EUR/GBP (ex. 12/29) we can assume that the EUR has weakened considerably against the GBP. Then we can look at the EUR/USD pair and check to see if there is any price stalling. If we do see the price stall we can look for a price reversal confirmed by oscillator divergence and/or candlestick formations.

In a range bound market, is the correlation between the EUR/GBP and EUR/USD as applicable? More specifically if we see both pairs trading in a range can we still say with confidence that the EUR is strong in the EUR/GBP and the USD appears weak in the latter pair? Or does this strategy only seem to work when the market is moving in a definitive direction?

Yes, even in a range bound market the charts will still be reflecting the overall strength or weakness of each currency pair. For example we can see that in the month of June when both pairs are relatively range bound, the June 11th point shows EUR weakness in both the EUR/GBP pair and the EUR/USD pair. The relative strength of each currency remains evident despite the market type (trending or range bound).