From the May 01, 2011 issue of Futures Magazine • Subscribe!

Reading forex memory with five-day Markov chains

"Chain gang" (below) shows a digital sentiment function for the euro/dollar pair in the two-month interval from Nov. 15, 2010, to Jan. 14, 2011. We can see both five-day single chains and their compositions in this chart. This result already conveys the market meaning, but it’s quite rough for trading. Our next step is to get a more precise characteristic, called a sentiment index, of one currency.

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Global sentiment index

When we analyze a currency, we do so in the context of pair quotations. We don’t research a currency individually, only how it relates to other currencies, which are in turn affected by others. It would be much more informative to get independent characteristics of separate currencies and then check them. For that reason, while building our sentiment index we look at currencies separately using the assembly of their crosses. For example, the sentiment index formula for the euro can be put as follows:

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Where “qi” are weight constants for 17 euro crosses: EUR vs. U.S. dollar, pound, Swiss Franc, yen, Canadian dollar, Australian dollar, New Zealand dollar, Argentinian Nuevo peso, Brazilian real, Chinese renminbi, Indonesian rupiah, Indian rupee, South Korean won, Mexican peso, ruble, Turkish lira and South African rand . The variable di(t) is a digital sentiment function for these crosses. Our index reflects the weighted sentiment for the euro on a global scale and is quite an accurate indicator. Similarly, we can calculate indexes for USD, GBP, CHF, JPY, etc.

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