Forex Market Breadth Analysis: Introduction

I have been talking about this in my real-time chatroom for quite sometime and many people email me for the specifics. Here is an introduction of market breadth on forex markets. Some part of this article could be very technical. If you do not understand any concepts I write here just comment about it so that I can explain further in follow up articles.

A Perfect World

If the flow of money is done only by real commercial activities only, the exchange rates among the countries will always maintain a pretty stable dynamic balance. Specifically, the following equation should hold:

What this equation says is that given currency #1 if you keep converting the money into another currency, and then into another currency again, where the exchange rate is provided to you in the form of a fraction or ratio function (e.g. EUR/USD is 1.3067) , as long as you are converting the currency back to what you are starting from, you should get the answer 1.

In reality, however, it is not true, even though it is very close.

Here is the exchange rate table for July 12, 2013 from Yahoo Finance website.

Let’s play with the exchange rates listed above to see how well the equation holds up.

EUR/USD x USD/GBP x GBP/EUR = 1.3067 x (1 / 1.5102) x (1 / 0.8652) = 1.00005

USD/JPY x JPY/EUR x EUR/GBP x GBP/USD = 99.285 x (1 / 129.7337) x 0.8652 x 1.5102 = 0.999958

See how close the answers are to 1?

There are several reasons why the answers are not exactly one.

The most direct cause of the discrepancies is the bid/ask spread. The price quoted in the table is not exact. It could be the bid price from one of the major forex firms, or it could be the average price across several firms. In any case, due to the bid/ask spread in forex, you will lose some money at every stage of the conversion as the brokerages are making some money off your trade from one currency to another.

A Dynamic System

The equation stated above is not something new in case you do not know of its existence until now. The importance of the equation is that it tells you when one currency moves in a particular direction against another one, it will affect the other exchange rates at the same time. There is no escape from the equation at all.

In another words, forex markets is a complex dynamic system where the changes in every exchange rates will affect all the other currencies at the same time. The feedback loop is so tight that the balance is maintained very closely down to 5 minute intervals.

Money Creation Issue

Each forex pair is essentially a ratio function for the dynamic flow of money from one currency to another. Normally money is not created out of thin air. Money is supposed to exist in one of the currency in the pair first before such flow (transaction) can take place. The catch, of course, is that forex transactions do not require the counter parties to have significant margin in place at all. Hence, money is indeed created from the forex transactions.

These created money causes imbalance in the currency flow when one or more currencies are accumulated in size significantly more than the other ones against a specific currency.

For example, when US dollar is gaining strength against Euro, British Pound, Japanese Yen and Canadian Dollar, that strength will have an effect on Australia dollar and New Zealand dollar. Until the imbalance is worked out, it will be difficult for a single currency to move against the pack.

Identification of the strength of currency flow on a specific currency against the other currencies is a form of market breadth. It is useful for spotting change in the overall direction of money flow for the specific currency. When one can detect a change in currency flow in early stage, good trading opportunities are found.

Sentiment Reading Is Not Market Breadth Analysis

When people think of breadth analysis on forex they would immediately associate that with the Commitment of Traders reports from the Forex future contracts traded at CME. That is just sentiment reading of the participants. That is not market breadth analysis.

In fact, it is not even a good sentiment indicator any more as there are too many sizable players in the future currency market that are not good market timers in the first place. In the old days, only the best and the brightest were trading in those currency contracts with size thus their actions became a great tool for the identification of potential trend change. Right now, due to the sheer number of new hedge funds entering the arena, the COT report has lost its value as a good sentiment timing tool.

End Notes

I am working on a few more instalments on forex breadth analysis.

I will also have weekly and daily update on the breadth readings made available on the website.

Should be useful tools for both swing traders and daytraders.

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