Bonus tip #2: Know the characteristics of the currency pairs you’re trading
(This is meant for FX traders. If you don’t trade it, then you can skip this section.)
Here’s the deal:
Not all currency pairs are created equal.
Some have trending behaviour, whereas some have mean-reverting behaviour.
Now you’re probably wondering:
“How do I know if a currency pair has a trending or mean-reverting behaviour?”
Here’s a backtest you can run to find that out on any currency pair…
- If the price breaks above the previous day high, go long
- If the price breaks below the previous day low, exit your long position—and go short
- If the price breaks above the previous day high, exit your short position—and go long
Clearly, when you run this “trend following” backtest, currency pairs with a trending behaviour should make money in the long-run.
And currency pairs which have a mean-reverting behaviour (with little-to-no follow through) should lose money in the long run.
Let’s have a look…
Trending currency pairs
For currency pairs that have a trending behaviour, this backtest will yield a positive outcome as the market continues trending in the direction of the breakout.
One example is GBP/JPY…
Mean-reverting currency pairs
As for currency pairs that have a mean-reverting behaviour, this backtest will yield a negative outcome as there’s a lack of follow-through whenever the price breaks out of the previous day high/low.
An example is AUD/CAD…
So now the question is…
“How do you profit from this knowledge?”
If you know which currency pairs have a mean-reverting behaviour, then you can use that “natural behaviour” to time your entries & exits.
You know that AUD/CAD tends to reverse at the previous day high/low.
So if you’re in a long trade, then you can use the previous day high to exit your trade (as this currency pair tends to reverse at the previous day high).
Alternatively, if you’re looking to short AUD/CAD, the previous day high is a possible level to consider as it tends to reverse at the previous day high.
This is powerful stuff, right?