The search for new trading opportunities is a constant challenge to the forex trader. Trading opportunities occur when fundamental or technical boundaries are probed, or broken. At these points, when patterns are changing or prices are at extremes, technical traders look for a retracement. Such retracements are known as a “reversion to the mean.” Traders who put on “bounce trades” off channel patterns and those who trade Fibonacci retracement levels are applying “reversion to the mean” concepts.
Trading opportunities also can be discerned by detecting fundamental and economic valuations that are at extremes. A famous example is the “Big Mac Index,” which illustrates the economic theory known as Purchasing Power Parity (PPP).
Purchasing Power Parity reflects the idea that currency variations between countries tend to be equal. In other words, if a basket of goods was the same in different countries, a unit of currency should buy the same amount of that basket. A basket of goods consisting of eggs, milk, a loaf of bread etc., can be used for calculating PPP because the basket can be identical for any country. When the cost of this basket gets out of whack between two currencies, some traders see this as an opportunity based on reversion to mean principles. The Organization for Economic Cooperation and Development (OECD) publishes this information. The best known expression of this PPP concept is the Big Mac Index, tracked by the Economist magazine. It is a serious tool for spotting long-term trading opportunities.
Essentially, the index reveals which currencies are overvalued or undervalued against the dollar based on the cost of a Big Mac. Since the Big Mac essentially is standardized in its ingredients and is sold in 120 countries, in theory, the cost of a Big Mac should be the same in Britain, France or China as in the United States. If it is not, this shows a valuation discrepancy. Ultimately, according to reversion to the mean principles, the markets will not sustain this discrepancy for too long. That there are price differences on the Big Mac between different countries is not an economic error, it is simply a clue that valuations are not in equilibrium. The expectation therefore is that an overvalued currency or an undervalued currency will revert to its fair value. How long will that take?
That, of course, is the key question. The trader can see that an overvalued Big Mac is an alert for detecting a new trading opportunity (see “Comparison shopping”). The best approach after locating the fundamentally mispriced currency is to look for entry locations that confirm a retracement is underway that will restore the balance between the currency pairs to fair value. There are a myriad of technical tools for this, including trend lines, Fibonacci levels and Bollinger Bands.
“PPP watch” shows current overvalued and undervalued currencies based on purchasing power parity put out by the University of British Columbia’s Saunder School of Business (it can be found at: http://fx.sauder.ubc.ca/PPP.html.)
The scan of the Big Mac valuations and the PPP charts of the OECD shows that the Swiss Franc represents an extreme overvaluation against the U.S. dollar and therefore traders should watch for buying opportunities in the USD/CHF pair.
Implementing Big Mac analysis and PPP theory should be done with longer-term perspectives of one year or more and should not include much leverage. As many reversion to the mean traders found out in 2008, certain market anomalies can grow and persist longer than most traders’ account balances. It takes time for fundamental forces to correct themselves. As a result, ETFs and options are excellent instruments for applying this theory.
In the coming years, more robust alternatives to the Big Mac Index will surely emerge. A contender may be the iPod, because it is a standardized global product. Either way PPP can be a useful tool in your basket of indicators.
Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at email@example.com.