In today’s Trading Strategy article we look at how to combine a long-term trading strategy with technical and fundamental analysis. This approach will give you a simple but effective guide to price movements and trading. We then look at how you can put your strategy into action by trading — or not — on three popular currency pairs.
Monthly charts tend to be better at signalling shifts in primary trends than shorter-term equivalents. Long-term charts are less subject to short-term market ‘noise’. An especially strong or weak month is often a good indicator of the direction of the primary, or overall, market trend.
Technical analysts have found that analysing the last three months of activity can be especially useful for gaining information about a long-term trend.
Whilst it is notoriously hard to pick market tops and bottoms, we have found that a three-month rotation around a new high or low can provide a strong signal that the medium- or long-term trend may be changing.
The ‘pivot swing’ around a new high or low can be a useful objective tool for identifying such peaks and troughs.
Don’t be fooled by the simplicity of the approach — analytical tools do not necessarily need to be complicated to be useful. At the same time, it is worth remembering there is no sure-fire thing in financial markets either.
The below diagram shows the ideal schema for the pivot swing strategy.
Not every pivot around a new high or low can be considered to be a ‘reversal’ — a major change in the direction of a price trend. Only those pivots where the third month shows a particularly strong change in sentiment and surpasses the level of the first month are valid. The point at which this occurs is labelled as the “confirmation” level on the above diagram. It is also the entry point for those wishing to trade the signal.
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Pivot swings are a technical device, but they can be combined with other indicators or fundamental insights to increase the reliability of the signal.
If a currency performs a pivot following a downtrend to a market low and is also heavily ‘undervalued’ (according to valuation models using fundamental data), it may be the perfect opportunity to buy and profit from an expected period of sustained appreciation. You can use the Bank of International Settlements (BIS) Effective Exchange Rates (EER) data* to evaluate how over- or undervalued a currency is.
An EER of 100 suggests a currency is ‘just right’ — that its current value is in line with its ‘true value’, a value that takes into account the currency’s economic fundamentals. A score over 100 is considered overvalued and below 100 is undervalued. If a currency is overvalued the assumption is that it will start to decline back to fair value eventually, and vice versa for a currency which is undervalued
The current EER scores for the four most heavily traded currencies in the world at the moment are shown below.
* The BIS’s EER is not the only valuation model. We are using it here as an example.
Below is an analysis of the current market situation for the three most heavily traded pairs using the pivot and valuation techniques outlined above.
A monthly pivot at the recent lows suggests the trend may have rotated higher. The exchange rate confirmed the signal when it broke above July’s 1.1791 highs in September.
Unfortunately, there has been no follow-through higher — as would normally be expected. However, the signal is not invalidated either (it would have to fall below August’s ‘hammer’ lows for that to happen).
It is still possible it could break higher. A move back above the 1.1815 September highs would reinvigorate the bullish signal and provide a fresh buying opportunity.
The Euro is considered undervalued compared to the US Dollar, with respective EERs of 95 vs 115. This further supports the hypothesis the pair may be about to change trends and move higher.
A bearish pivot occurred during highs of April 2018 and correctly signalled the start of a downtrend. Since then, there has been no more pivot signals.
This suggests the trend remains bearish, despite a recovery in September and October.
Sterling is undervalued compared to the Dollar (EER of 99 vs 115). This poses an upside risk to the outlook which is at odds with the current bearish trend.
Whilst the signal back in April was fresh and tradable we would not recommend joining the downtrend at this late stage, without a further bearish pivot in price.
USD/JPY completed a monthly pivot higher in September that produced a bullish signal for the pair. Confirmation came when the market broke above the 113.18 July highs in September.
The pivot adds evidence to suggest the pair will continue trending higher and although the entry point at the July highs has now been surpassed, one option for traders wishing to jump on this trend would be to place a limit order placed at that level.
The only problem is that — much like GBPUSD — the yen is the more undervalued of the two: EER of 85 vs 115. Although currencies can remain undervalued for long periods of time this does detract from the attractiveness of the set-up.
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