Extra tip #2: Know the characteristics of the currency pair you are trading
(This applies to foreign exchange traders. If you are not trading, you can skip this section.)
This is the transaction:
Not all currency pairs are equal.
Some have trend behavior, and some have mean reversion behavior.
Now you may want to know:
“How do I know whether a currency pair has trend or mean reversion behavior?”
Very good question.
This is a backtest that you can run to find out the result of any currency pair…
- If the price breaks the previous day’s high, go long
- If the price falls below the previous day’s low, exit the long position and go short
- If the price breaks the previous day’s high, exit the short position and go long
Obviously, when you run this “trend following” backtest, currency pairs with trend behavior should make money in the long run.
In the long run, currency pairs with mean reversion behavior (almost no follow-up) should lose money.
Let’s take a look…
Trending currency pairs
For currency pairs with trending behavior, as the market continues to develop in the direction of breakthrough, this backtest will produce positive results.
An example is GBP/JPY…
Mean reversion currency pair
For currency pairs with mean reversion behavior, this backtest will produce negative results because there is a lack of follow-up whenever the price breaks through the previous day’s high/low.
An example is the Australian dollar/Canadian dollar…
So the question now is…
“How do you benefit from this knowledge?”
If you know which currency pairs have mean reversion behavior, then you can use this “natural behavior” to determine your entry and exit time.
You know that the AUD/CAD tends to reverse the previous day’s high/low.
Therefore, if you are trading long, you can use the previous day’s high to exit your trade (because the currency pair tends to reverse at the previous day’s high).
Or, if you want to short the AUD/CAD, the previous day’s high is a possible consideration level because it tends to reverse at the previous day’s high.
This is a powerful thing, right?